Thursday, September 01, 2011

Fixed Return Investments Vs. Dividend Income

One day my younger brother called me and he sounded very confused. He also has a lot of believe in Value Investing. But when learnt that value investors has more inclination for dividend income than market price appreciation of share so he became confused. The reason for his confusion was the level of dividend income he could have made from value investing.

He said, if I am investing for dividend income which hardly gives me 3% to 4% annual returns, why not invest in fixed income investment options which are almost risk free and given almost 5% after tax returns?
I know this is one stage of value investing that all value investors pass one day or the other. This doubt is inevitable and the confused person needs proper counseling to overcome this state of mind.

It is true that dividend income is not as high as people conceptualize the returns of share market to be. Most of the share market investors when they are talking about share market investment and profits they are talking about returns related with market price appreciation.

But let me tell you value investors do not consider market price appreciation while analyzing future returns, they focus on long term holding and dividend income during this period. In fact value investors like Warren Buffett buys shares in order to hold it forever, because preferably will never sells his holdings till they have opportunity to pay high future-returns. These returns can be in the form of dividend income or bonus shares.

But coming back to the doubt of my brother, why investors shall invest for dividend income leaving aside a risk free which at time can pay higher returns (like fixed deposit of bank). These days banks offers interest on fixed deposit close to 7%, which will amount to net after tax gain of 4.9% per annum.

If you will research stocks listed in stock market you will find that the dividend yield generated by those stocks are sometimes as high as 0.5% to 3% (dividend earning is non-taxable). So this is reason why my brother was confused that if value investing is paying him just 3% and banks are paying him 4.9%, then why at all he should go for share market investment?

If you will ask me, I think this is a very important point that needs to clarified for all new and budding ‘value investors’. In order to understand this I will first show you a table:

No. of YearsPAT (@ 10% per annum increase)Outstanding SharesEPSTotal Dividend Disbursement as % of EPSTotal Dividend Disbursement in Rs. Purchase Price / ShareDividend Yield

The above table lists the performance of a hypothetical company over a span of 10 years from today. Suppose you as a share market investor buys share of this company at market price of Rs 120, and dividend Yield @ 2.5% per annum. Net Profit (PAT) of this company is increasing at the rate of 10% per annum.

And this company has a policy of disbursing 30% of their earnings to shareholders as dividend. So you as an investor who has bought the share at Rs 120 each, see how your dividend is increasing from first year @ 2.5% p.a. to tenth year @ 6.48%. This explains why Buffett asks all value investors to buy value shares and hold them forever.

The more is your holding time the higher will be your dividend income. Unlike your fixed deposits following distinctions are worth noting:

(1)    Unlike fixed deposits interest-income, dividend-income is the actual cash you receive each quarter/year from the company. The dividend income you are receiving from the company irrespective of the price volatility of the share market.
(2)    As there is actual cash-in-hand income in the form of dividends, you can re-invest them again to buy more quality-stocks which pays even higher dividends.

If will give you another example, as a value investor you are always focused in buying quality stocks at undervalued prices. Often market miss-quotes some quality stocks, and hence they become undervalued. Value investors takes examples of this market price volatility and grabs such miss-quoted shares. Let us see what happens to your dividend yield if you buy the share (tabulated above) at an undervalued price of say Rs 68.

No. of YearsPAT (@ 10% per annum increase)Outstanding SharesEPSTotal Dividend Disbursement as % of EPSTotal Dividend Disbursement in Rs. Purchase Price / ShareDividend Yield

But buying this share at undervalued price levels, you have not only increased you current dividend yield but also after ten years of holding your tax free dividend earning is as high as 11.44%. Most of the stock market investors will be more than happy to make this kind of earning by following buy-and-sell strategy. But you are not selling the shares, instead you are making 11.44% earning just by holding.

This is in line with the value investing approach of stock market. Buy low and hold-on forever. Now I hope you know what is the reason why buying-low and holding-on forever is so important. Now you will know why dividend cash flow model is used by value investors to do stock valuation.

What is the catch? It cannot be so easy, just buying stocks of companies that pays high dividends and holding them till eternity will make your rich. This investment plan is too easy. Yes you are right, the catch is in the “PAT” column and in the “Total Dividend Disbursement” column.

Unless company is continuously increasing its profits after tax (PAT) each year at the rate of 10% per annum you will not end up making good dividends as expected. This is the reason why Warren Buffett always insists on buying only ‘quality companies’. A company with strong fundamentals will only be able to multiply their earnings in long term. Ultimately the skill of the ‘operating management’ of the company and their ‘competitive advantage’ will help in fast multiplication of PAT earnings.

So, just by selecting company that pays high dividend today is not helpful. You must also look at their future prospects, that whether they will continue to pay high dividends in future. Whether the management has any intention to continue sharing the company’s profits with their shareholders.  Most of the companies (as a policy) do not pay good dividends. So selecting a quality company that pays good dividends is like selecting a needle in the haystack.

Again, there are company that may have paid high dividend today just to attract shareholders. If you will check their past history, they may be sharing only 5% of their PAT in the form of dividends. So disbursing 30% of profits as dividend become a one-off case this year. This is the reason why it is very important for value investors to check the past dividend-payment history of companies.

If they are paying high dividends consistently in the past then most likely they will continue to do so in the future. But surely this decision is surely dependent on the decision of Board of Directors. This is another reason why Warren Buffett gives so much importance on investing in only those companies that has capable and honest management. Not only this management will increase the profit earnings of the company but will also honestly share profits with its shareholders.

Dividend yield may be low today, buy a quality company always strives hard to increase this yield year after year for their shareholders. As a value investors you will also contribute your part to the dividend yield by buying shares at undervalued price. This is one tool that is in your hand, develop your method to value companies. List down and Keep track of quality companies (companies that has strong business fundamentals).  If you do not know how to do stock valuation then your first step will be to learn to read financial statements of companies.
Do you like this post?


Post a Comment

Related Posts with Thumbnails