Money wise

INVESTING

When equity markets tumble, investors start looking at various ratios to identify stocks that will give them better returns. One such route is the dividend-yield ratio. Normally, this works out well because investors get an opportunity to pick stocks where they earn a good amount in the form of dividends, in addition to capital appreciation over time.

Using dividend yield: The dividend yield for a stock iscalculated as the dividend per share of the company divided by the market price of the stock. This ratio also shows the amount of dividend, in terms of percentage, that investors will earn, if they invest in the stock at a particular price.

Whenever there is a rally in the market or a boom in the market, the dividend yield falls significantly due to a rise in the share prices. For instance, during the 2003-07 bull run, the value even dipped below 1 per cent for many companies.

In times of a market fall, the value of the dividend yield goes up for investors wanting to invest in the company. This is often used as a strategy for investment. However, there are a couple of reasons why such a strategy can become a spoilsport for investors.

Dividend rate: The dividend yield is calculated by looking at the previous dividend declared by a company and using this with the current market price. Thus, if a company has declared a dividend of 40 per cent on the face value of Rs 10, this will be a dividend of Rs 4 per share. If the share price is Rs 80, the dividend yield comes to 5 per cent.

However, in case the performance of the company is adversely affected, the dividend rate will fall. For instance, the particular company made a profit of Rs 50 crore in the past year and paid out a 40 per cent dividend, resulting in a 5 per cent yield. Now if the profit plummets to Rs 20 crore, then the company might cut the dividend rate to 20 percent.

In this case, even if the share price remains constant, the dividend yield will be half. This directly affects the dividend yield calculations even though there has not been a change in any other factors.

At the same time, other ratios like the earnings per share, return on net worth, other return ratios as well as the price-to-earnings ratio will change due to the reduced profits of the company too and this can impact the share price. In some cases, even if there is not a sharp fall in profits, the dividend rate might be reduced.

Share price fall: Another aspect of the entire dividend yield working is that this considers the return only from the angle of the dividend earned. For the investor, the total returns consist of additional areas too, which includes the return in the form of the capital gain or loss too.

When investors buy a particular share at a specific price, they are trying to assure themselves of a certain return on the dividend side in addition to the capital gains.

So a fall in the price of the share can be offset by a good gain on dividend and vice versa. That is, if an investor buys a share at Rs 100 with a dividend yield of 6 per cent and then there is a fall in share price to Rs 90, the 10 per cent loss wipes out the gains. In this case, the dividend yield for new investors will be higher, but for existing investors there is pain to be endured.

The writer is a certified financial planner