Monday, August 29, 2011

Is worth to invest money in shares only for dividend income?

It creates a lot of difference in the investment approach if you are investing with objective of ‘market price appreciation’ or with an objective of ‘dividend income’. When Warren Buffett says that ‘he buys shares to hold it for lifetime he is not joking, he is actually hinting at dividend income. Some may say that dividend income is so low that how can one base their investment on basis of only dividends.

In this article we will see how advantageous it is to consider dividend income as stock investment focus.
Warren Buffett is a champion of the game of investment. When a champion says that buy and hold shares for a lifetime then it must mean something important. Buffett will not just buy shares for holding it meaninglessly for lifetime. I believe that in case Buffett is not making money by selling shares then he is making it from dividends for sure. So let’s see how value investing makes it possible for Buffett to earn outstanding dividends from share market investments.

It is a well known fact that Buffett prefers investing in only large cap, blue chip stocks. These stocks has an established market of their own and are very reliable even in worst of times. The reliability of these companies comes from their ability to increase/ improve their net worth, earning per share and net cash flow year after year. A company which has capability to manage these three parameters (even in worst of times) will do wonders in their prime.

If company is performing wonderfully it means they are managing good profits which ultimately translates into healthy dividends. But how Buffett manages to earn high dividends?
It is common to see that all large cap or blue chip stocks do have a good dividend yield. So when we say buy big and established companies stocks it necessarily wont yield high dividends. So what is the way out? This is where value investing shows its strengths and advantages.

What is value investing? It asks us to buy only undervalued stocks as compared to its intrinsic value. Intrinsic value of a company is determined by ability of business to generate income for its shareholders. So in short we can say that undervalued stocks which has strong future earnings-growth possibilities shall be our focus. But there is a big fallacy in this statement. On one side we are talking about large cap, blue chip stocks and on the other side we want them to be undervalued, this is not common.

All blue chip stocks, if not always, trades for majority of times at overvalued prices. To give you an offhand example of a blue chip stock say ‘X’. If its book value is $1 then it will actually trade in the market somewhere close to $4. So this is trading at four times its book value. This is very overvalued. Almost all large cap stocks trade at this price multiple (some even higher) during ‘bull runs’.

Small and new investors often gets attracted to stock market during bull runs. Bull run is good for those investors who had been already invested in stock market at lower levels, so that during bull run either they are selling or relaxing (definitely not buying). But small investors gets misleaded and are drawn into buying shares at these price levels.

In bull runs, the market price of stocks are too overvalued. Such price levels can never be justified even if those investors hold those stocks for next 5 years. Such investors are loss in both ways, neither there is a possibility of market price appreciation beyond those price levels, and dividend yield is also very-very low. Let me explain you with an example. Suppose a company ‘X’ whose net profit is say $100 (market price is $4). The board decides to disburse 30% of net income as dividends to shareholders. Do dividends to be paid to share holders will be $45.

Assuming that there are 1000 number of shares outstanding in the market, hence dividend paid per share is $0.045 per share. Market price of share is $4, so its dividend yield will be 1.125%. But in case the same share is suppose trading at $1 per share in market (this differential is possible in case of market crash as that of year 2008) the share will give a dividend yield of 4.5%. Then comes the power of compounding which will increase your dividend earning possibilities with growth is earning of companies.

So when Warren Buffett says buy shares of big companies at undervalued prices he is actually hinting at buying shares of company which can increase their earnings year after year and also provides high dividend yields.

It is amazing that how easy it is to make money from share market investments just by waiting for the prices to fall to undervalued levels. It is true that this wait can be at times very long, but it’s worth a wait. I know i am talking only to those long term investors who are ready to buy shares and hold forever.

Wealth creation is not a one day process. It gets build-up bit by bit from years of perseverance and careful investing. Knowing intrinsic value of companies is important. Long term investors must know how to read financial statements of companies. Estimating intrinsic value is impossible if you cannot read and analyze financial statements of companies. Believe me making meaning out of financial statements is not as hard as it seems. Go ahead and start reading financial statements, buy undervalued shares at high dividend yields and stay invested for long term.

Wish you best of luck and have a happy intelligent-investing.
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