personal finance

Using dividend yields to pick stocks


Retail investors typically find it challenging to increase their exposure to equities during uncertain times owing to the risk of losing a significant amount of principal due to steep correction. However, if an investor is investing for the long term, the stock with higher dividend yield could offer attractive option to reduce the cost of acquisition and earn tax-free income. It must be noted that dividend income is tax-free in the hands of individuals.


1. What is dividend yield?


The dividend yield is computed by dividing the dividend declared by the company in a fiscal year by the current stock price. Alternatively, it can be calculated by the cumulative dividend per share in the past four quarters divided by the current stock price. Given the dividend yield has stock price as the denominator for computing, the dividend yield is inversely proportional to the stock price, which means a drop in the stock prices results in dividend yield to go up. Other things remaining equal, the higher the dividend yield, more attractive is stock for investors.

2. What are the benefits of buying high dividend yield stocks?

The continuous dividend payout reduces the cost of acquisition for investors. For instance, if an investor bought the stock at Rs 100 share in 2013 and received Rs 5 per share of dividend in the past five years. The cost of acquisition for investors is coming down by Rs 5 per share every year. This has been one of the key reason some investors looking at the total return of stock to compute gain or loss. The total return included stock appreciation during the period of observation and dividend received during the same period.

3. How should an investor interpret dividend yield?

Typically, investors compare dividend yield ratio to current risk-free rate of return — measured by government 10-year bond yield. If the gap between dividend yield and risk-free return is compressing it offers an attractive opportunity for an investor as a dividend received could lower opportunity cost of putting up the same money in the fixed deposit instrument. An investor should look for the companies having dividend yield more than 3-5 per cent and having consistent dividend payout history. State-owned companies such as Coal India, HPCL, Indian Oil have historically had higher dividend yields as their dividend payouts have been quite consistent.

However, an investor should stay away from stocks that have seen significant cracks due to company-specific reasons that could hurt future profit. In this case, the dividend yield will be optically high. Besides this, an investor should strike off higher dividend yield due to one-off special dividend to calculate dividend yield.





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