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Tuesday, March 15, 2016

Why to Choose Dividend Yield Stocks instead of Bank FDs?

What is Dividend Yield?

Dividend yield is the ratio of dividend per share (in Rupees) and the market price of the share. It is expressed in percentage, just like the yields on fixed deposits (FDs).

Dividend Yield = ( Dividend Per Share / Market Price ) * 100

For example, if the dividend per share is Rs. 10, and the market price of the share is Rs. 400,
Dividend Yield = (10 / 400) * 100 = 2.5%

Now, if the dividend is fairly consistent, a parallel can be drawn to banks FDs.

Isn’t it similar to investing Rs. 400 in an FD, with the interest rate being 2.5%?
On the face of it, yes. But remember, the interest received on bank FDs is fully taxable in the hands of the investor, while dividend is tax free. Thus, in effect, it is equivalent to investing Rs. 400 in an FD, with the interest rate being 3.57% for an investor in the highest tax bracket.

What kind of companies to invest in?
One & only condition – the dividend should be fairly consistent. Only then, a conservative investor can utilize this strategy in place of investing in FDs.

So, we need to look for companies that have a record of consistent dividend payments. And the best part is there are many good companies that pay regular dividends.

In general, companies in high growth industries, like Telecom or Information Technology, plow back most of their profits to fuel their growth. So, they usually don’t declare attractive periodic dividends.

But companies that are in mature industries and are the leaders in their fields usually have lesser need to reinvest their profits. These are the companies that declare handsome dividend, time after time. And these are the companies you should invest in to implement the strategy of dividend yield.

Advantages of the Dividend Yield Strategy
There are two big advantages of the dividend yield strategy:

1. Capital Growth:

Since you invest in stocks as a part of this strategy, naturally, you also reap all the benefits of investment in stocks. And the biggest advantage is Capital Growth.

This means that the dividend you receive gives you a fairly regular income, and the capital growth (in the form of an increase in the stock price) keeps you ahead of inflation.

2. Dividend Yield increases over time:

The calculation of dividend yield uses the market price of the stock. Thus, in our example, dividend yield was 2.5%.

Now, since you are a long term investor, you buy a stock and hold it for a long term. During this time, the stock may undergo stock splits and bonuses. Also, the price of the stock goes up over time. This means that although the prevailing price of the share is high, your cost of acquisition of the stock could be fairly lower compared to the market price.

In that case, what is the yield for you? Let’s stick to our example – the market price is Rs. 400, and the dividend per share is Rs. 10. Also, due to increase in the stock price over time and due to stock split and bonus, your cost per share is Rs. 200.

In this case, although the dividend yield is 2.5%, the yield for you is:

Yield = (Rs. 10 / Rs. 200) * 100 = 5%

And this is equivalent to an FD with the rate of interest of 7.14%. Isn’t this great? This means that the dividend yield strategy give you not just regular income and capital growth, but also an increase in the regular income over time!

What about Taxes?
As discussed earlier, the interest received on bank Fixed Deposits (FDs) is fully taxable in the hands of the investor, while dividend received is tax free. Thus, the effective yield for an investor in the highest tax bracket is even better.

Effective Yield = Dividend Yield / (1 – Your tax rate / 100)

Thus, for people in the highest tax bracket,

Effective Yield = Dividend Yield / (1 – 30 / 100),

E.Y = Dividend Yield / (1 – 0.3)

E.Y = Dividend Yield / 0.7

One very important point to note is that dividend is tax free only for long term investors. If you buy a share and sell it after receiving the dividend, it is called Dividend Skimming. Dividend received in this case is fully taxable in your hands.

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