Let’s talk about dividends, first off dividends are basically a payment every single quarter of the fiscal year so, if a stock or company is producing X amount three or four quarters a year then a person is paid out three or four times now. You can change the dividend payout rate if you are a major shareholder. Then you can go and vote and have the dividend payout only twice a year. You could have it pay off four times, six times a year this is going to depend. But payment of most dividends is in every 4 months. Payment for the same is in cash or you can get paid in stocks, bonuses. These are the typical ways that companies will pay out a dividend.
Now, a lot of amateur or naïve traders love dividends or they will fall in love with them
For instance (Hypothetical case):
Mr. Mike put 10,000/- in Tata Motor and Tata Motors pay out a dividend every 4 months. So, Mike will get a dividend of 200/-, as Mr. Mike is getting free money every four months, Now again company decided to make an extra payout of 400/- again after another 4 months. So, basically, Mr. Mike will fall in love with Tata motors stocks. He will think that lets buy another stock also in the same sector. But always remember not every stock pays out the dividend. To choose stocks which pay the dividend is an expert work.
If you are an investor, you must be aware of the fact that the market is very volatile and the stock prices fluctuate every single minute.
So let’s get back to Tata Motors, say Mr. Mike bought stock at Rs. 30/- for 100 shares at Rs. 3000/-. But the stock can go up and down and in time if the stocks go up let’s say Rs.40/- you made out like a king because now you’re getting stock appreciation. Further you’re getting your dividend every 4 months. Now what happens though is if the stock is at Rs.30/- and it declines and it goes to Rs.20/-all of a sudden total value of your total invested amount comes down. Obviously you lost some portion of your investments.
Which stocks to pick?
So let’s just something to understand about dividends is that it’s fluctuating on the stock price. Even though you’re getting that dividend or additional bonus or additional revenue and that sounds great and amazing. But the reality you also want to pick stocks that are also in appreciation or on an incline. At least something fairly stable otherwise you’ll get depreciation of the stock. Even though, you know you’ll still get your dividend but the depreciation of the stock will come into play and you never know if a stock will actually fold or close you might be thinking well then I’ll just buy more shares but be careful you never know company can go bankruptcy.
But the main question here is which ratios to look for while evaluating dividend stock. There are 4 such ratios which will give you a broader picture of the stock
1. Dividend Payout Ratio:
Investors are particularly interested in the dividend payout ratio because they want to know if the companies paying out a reasonable portion of net income to the investors
Most start-up companies and IT companies rarely give dividends at all.
The payout ratio provides an idea of how well earnings support the dividend payments. More Mature companies tend to have a higher payout ratio
2. Dividend Coverage Ratio:
Calculation of dividend coverage ratio is profit after tax less preferred dividends divided by dividends paid. Dividend coverage is a measure of an organization’s ability to pay the dividend. It shows how many times the profits of an organization could have been used to pay the dividend
If any company’s dividend coverage ratio is 2, this means that the organization profit was twice the amount of dividend paid out to the shareholders.
Generally, organization aim is to sustain a dividend cover of 2 in order to avail an adequate financing through retained earnings. While at the same time, it provides a reasonable return for its shareholders. A low dividend coverage ratio let says 1.5 may suggest that the organization may not be able to maintain its present level of dividend should profit fall. A high dividend coverage ratio means the company is retaining a higher proportion of its earnings for future growth. which may lead to future increases in dividend payments or increased share price values.
3. Free Cashflow to Equity:
Free cash flow is incredibly important to an Investor. This is probably the most critical think an investor look at and interestingly it’s not a number you can come up with very easily. Free cash flow is what you would actually get back in your pocket if you own the whole company and you get to collect money.
There are 2 prime reasons
1. The money we would get if we own the business that we can go, allocate anywhere we want
2. It’s the money that we company can allocate where it wants as well
FCFE = Net Income – Net Capital Expenditure – Change in Net Working Capital + New Debt – Debt Repayment.
4. Net debt to EBITDA ratio:
Analyst use Net debt to EBITDA ratio to determine a company’s ability to pay its debt. It is calculated as
Net debt to EBITDA=Debt – Cash / EBITDA
High ratio of Net debt to EBITDA reveals a company that’s deep in debt it will have a lower credit rating and be forced to offer higher yields on bonds. Generally, the ratio of four or greater than four is considered too high through the benchmark of specific industries should be weighed as well.