Dividends

A company that makes a profit has two choices: keep it and put it to work, or hand some of it to the owners. A dividend is the second.

The mechanics

The board declares a dividend of, say, ₹8 a share. Anyone holding shares on the record date receives it; the market marks the ex-dividend date, from which a buyer no longer gets that payment.

On the ex-dividend date, the share price typically drops by roughly the dividend. That is not the market disapproving — it is arithmetic. The company has just sent ₹8 a share out of the door, so it is worth ₹8 a share less than it was the day before.

This is worth sitting with, because it disposes of a common confusion: a dividend is not free money. You have not gained ₹8; you have converted ₹8 of share price into ₹8 of cash. Whether that is useful depends on whether you wanted cash.

Yield, and the trap inside it

Dividend yield = dividend per share ÷ share price.

A ₹8 dividend on a ₹200 share is a 4% yield. Simple, and it hides something.

The yield can rise for two opposite reasons:

The dividend went up. The company is paying more. Good news, probably.

The price went down. The dividend is unchanged, and the yield rose because the denominator collapsed. That is not good news at all — the market has decided the business is in trouble, and often it is right.

A screener sorted by yield shows both at the top, indistinguishable. Many of the highest-yielding shares at any moment are simply the ones that have fallen the hardest, and the dividend that produced the headline yield is frequently the next thing to be cut.

The check is one line: did the dividend rise, or did the price fall? Look at both over three years and it is obvious.

The payout ratio

Payout ratio = dividends ÷ earnings. What fraction of the profit is being handed out.

It tells you two things.

Whether the dividend is affordable. A company paying out more than it earns is funding dividends from reserves or borrowing, and that cannot continue. A payout ratio above 100% is a question, not a feature.

What the company thinks of its own opportunities. A business reinvesting most of its profit is saying it can earn a good return on that money. A business paying most of it out is saying it cannot find much worth funding — which is honest and can be entirely correct for a mature company.

Neither is better in the abstract. A high payout from a company with nothing to build is sensible. The same payout from a company that should be investing is management giving up.

Should you prefer dividends?

Two honest positions, and the site takes neither.

For: cash in hand is certain, it forces discipline on management, and for someone living off a portfolio it is income without selling anything.

Against: a rupee reinvested in a business earning good returns compounds, and a rupee paid out is taxed and then has to be reinvested somewhere by you. Chapter 8 of Finance 101 explains why that difference matters over decades.

What is not a valid argument is that dividends make a share safer. The price adjusts by the payment, and a company can pay a dividend in a year it is destroying value.

Tax

Dividends are taxable in your hands, at your slab rate, which makes the after-tax return on a dividend lower than on the same value left inside the business for someone in a high bracket. The tax subject covers how this interacts with capital gains; chapter 7 of Finance 101 covers why tax before inflation is the order that matters.

The point

A dividend converts share price into cash; it does not create value. A high yield is as often a falling price as a generous payment, and the payout ratio tells you whether the company could find anything better to do with the money.