The general perception among investors is that shares mean price appreciation. Though this is right, many are not aware that equity shares can also be an attractive alternative source for generating regular income. By focusing on price appreciation, investors usually miss out on dividends, which are part and parcel of equity investing.
With many shares providing income in the form of dividends, one can simply construct a portfolio consisting of high dividend-paying shares, which will generate a significant amount of current income. Let us see how to construct a portfolio comprising such dividend-paying stocks.
Understanding dividends
When a company makes a profit, there are three ways to spend it. First, reinvesting the profits into
the business, which is known as plough-back. Second, pay back either full or partial profits to shareholders as dividends and, third, buy back shares either with full or partial profit.
Dividends are generally paid by companies in between two balance sheet dates. They are not an expense from the company?s point of view, rather a redistribution of earnings among the shareholders.
Even when a company makes a loss, it can pay dividends to shareholders out of its past profits. At the same time, there are companies that don?t pay any dividends despite making a profit.
In general, fast-growing companies often pay less or no dividends while slow-growing companies pay higher dividends. If your portfolio includes some high-dividend paying shares, it ensures regular income. This strategy is extremely useful for those with no regular income, or retired people with a reasonable amount of risk appetite.
Identifying dividend-paying companies
One of the most common questions in the mind of the investor is how to identify dividend-paying companies. The following are some indicative methods.
First and foremost, look for companies with a long dividend history. Generally, companies with a long dividend history won?t change their policy overnight.
Second, look at the company?s payout ratio in terms of earnings per share, which essentially measures how much the company is paying its shareholders out of its earnings. Choose companies with a payout ratio of more than 80%.
Third, it is better to choose companies that have a worldwide market presence, which may provide a hedge against inflation and other country-specific issues.
Fourth, look for companies that are known for a professional management, which has a reputation as being investor-friendly. Also, do some research on how the management navigated during difficult financial times.
One needs to look at various other factors ? companies with lots of cash, stability of products/ services (whether the company?s offerings are well-entrenched or not), whether the company sticks to its core business activities, buyback history, dividend history, and the like.
In general, dividend-paying companies have better stability of earnings over a period of time and stronger cash flows.
It?s important to note that the steps indicated above for identifying dividend-paying companies are not absolute or all-encompassing. But, these are indicative points that provide insight and resources for accumulating dividend-paying stocks in your portfolio.
These points will help you identify and buy the most rewarding stocks, which derive the maximum possible regular income from your hard-earned savings.
Diversify and reinvest
Having chosen companies based on the above criteria, you need to diversify across five to seven industries at the very least. If your dividends fall, diversification makes sure that only a fraction of your holding gets affected.
If you receive dividends when you don?t require money, reinvest the dividend. This can add a surprising amount of growth to your portfolio with minimal effort.
To conclude, a great income-generating portfolio ? by means of dividend or any other asset portfolio for that matter ? takes time to build. So, investors need to have patience and perseverance, and they need to constantly monitor and shuffle their portfolio as and when required.
Investing in dividend-paying shares for the long term is an excellent choice for investors looking to gain big over a period of time.
THE RIGHT STRATEGY:
Look for companies with a long dividend history. Generally, companies do not break away from convention
Check the payout ratio in terms of earnings per share; choose those with a payout ratio of
over 80%
Look at factors such as cash situation, well-entrenched products, buyback history, etc
Choose companies with worldwide market presence, which provides a hedge against inflation and other risks
Opt for companies known for a professional management that has a reputation of being investor-friendly
Diversify across a minimum of 5-7 industries
The writer is associate professor of finance and accounting at IIM Shillong
