Home/Blogs/Dividend yield is a great idea but beware the dividend trap

Dividend yield is a great idea but beware the dividend trap

Many investors find high dividend paying stocks attractive as it assures them a tax free income on hand. While there are a variety of measures for dividend, one of the most popular measures from an investment perspective is the Dividend Yield. Dividend yield measures the yield that you earn on the stock in the form of dividend at the current market price. Statistically, dividend yield can be represented as the following equation

Annual Rupee Dividend on the stock)/(Current Market Price of the stock)

Therefore if a particular stock has paid full year dividend of Rs.8 and is currently quoting on the NSE at Rs.225, then the dividend yield of the stock will be 8/225 = 3.56%
The dividend yield equation above can be further broken up into two sub-segments as under..

(Annual Dividend)/(Net Profit)  X  (Net Profit)/(Current Market Price)

In other words, the dividend yield can also be explained as the product of the Dividend Payout ratio and the Earnings Yield of the stock Markets. Remember, the Earnings yield is nothing but the inverse of the P/E ratio. But then why is the study of Dividend Yield so important when it pertains to stocks. First, a look at some attractive dividend yield stocks in India

Company NameCMP (7th Sep 2017)Annual DividendDividend yieldHindustan ZincRs.304.35Rs.29.409.66%SJVNRs.33.05Rs.2.758.32%Coal IndiaRs.255.00Rs.19.907.80%63 MoonsRs.72.60Rs.5.006.89%HPCLRs.461.95Rs.30.006.49%

Source: Moneycontrol

The importance of dividend yield for investors
The concept of dividend yield is simple to understand and calculate and hence a lot of investors tend to use this measure quite extensively. Here is why it is critical

At a broad market or index level, the dividend yield gives a quick idea of whether the overall market is overpriced or underpriced. In fact over longer periods of time, the Dividend Yield is more stable than P/E ratio and P/BV ratio as a measure of value

For stocks in general, an attractive dividend yield provides a level below which the price does not fall. This is especially true for large cap players in the market which have established track records of performance.

Dividend yields need to be understood in post-tax terms. Currently, dividends on equities up to Rs.1 million per annum are entirely tax free in the hands of the recipient. That covers most of the small and medium sized investors in India under its ambit.

Why you need to beware the dividend trap?
However, there has rarely been a positive correlation between high dividend yields and stock market returns. In fact, companies with high dividend yields tend to underperform stocks that have a low dividend yield. To understand the reason for this phenomenon, you need to understand the dividend trap. There are 3 components to the Dividend Trap argument

1.  High dividend yield companies have fewer investment opportunities
This has been observed not only in India but across the world. High Dividend yield companies are normally stable businesses with limited growth and investment opportunities. That is one of the reasons a larger chunk of the profits are paid out as dividend to shareholders. From a market valuation point of view, growth prospects and ROE matter a lot more than stable dividends. Which is why, there are still buyers for Maruti and Eicher Motors at low dividend yields but few are interested in buying an REC or PFC despite their attractive dividend yield.

2.  High dividend yield companies are more an outcome of weak prices
This is in a way a continuation of the previous point. Stocks with higher dividend yields tend to get into a kind of a vicious spiral. Due to weak investment opportunities, you do not get price appreciation and when the price falls the dividend yield becomes all the more attractive. More often than not, the high dividend yield is an outcome of the lack of traction in stock prices, which is not a very encouraging situation for investors.

3.  Companies may increasingly prefer the buyback route
In the 2016 Union Budget, the Finance Minister inserted a new clause wherein dividends on equities above Rs.1 million per year were to be taxed at 10% per annum. This largely reduces the tax efficiency of dividends for large investors, major stakeholders and the promoter groups. Over the last few months, many companies have chosen to reward their shareholders through buybacks rather than through higher dividends. That may be largely eroding the utility of dividend yield as a measure of value.

To understand the reason for the existence of the dividend trap, you need to understand that most of the high Dividend yield stocks tend to have a high earnings yield too. Since the P/E ratio is the inverse of the earnings yield, this indicates a low P/E ratio. That explains why most high dividend yield stocks tend to quote at cheap valuations. This low P/E Ratio is more an indication of weak growth opportunities and limited value creation potential rather than a sign of the stock being underpriced. So, next time you try to buy a stock purely based on its dividend yield; remember that you may be unwittingly walking into the dividend trap!

You may also like…

Be the first to read our new blogs

Intelligent investment insights delivered to your inbox, for Free, daily!

Partner with us
Become a Partner