INVESTOR LETTER #38
What Are Dividends & Dividend Yield? Meaning, Formula & Importance
Learn what dividends and dividend yield are, how dividend yield is calculated, and why investors use them to evaluate shareholder returns, income potential, and a company's capital allocation strategy.
INVESTOR NOTE
A business owner thinks in decades. A speculator thinks in minutes.
Owning a Business That Pays You
Imagine you and your siblings own a small apartment building that earns rental income every month. After paying all expenses, there is still money left. You have two choices. You can distribute some of that money among all the owners, or you can use it to buy another apartment and grow the business. Public companies face the same decision every year. When they choose to share part of their profits with shareholders, that payment is called a dividend.
A Reward for Being an Owner
Many people think the only way to make money from stocks is when the share price goes up. That's only part of the story. Some companies regularly share a portion of their profits with shareholders, giving investors an income simply for remaining owners of the business.
Not Every Company Pays Dividends
Imagine a young restaurant that's becoming popular. Instead of giving profits to its owners, it uses every rupee to open new branches. The owners don't receive cash today, but they hope the business becomes much larger tomorrow. Many fast-growing companies think the same way. They retain profits to expand rather than distribute dividends.
Why Mature Businesses Often Share Profits
Now think about a well-established business that already has stores across the country. It doesn't need huge amounts of money to keep growing. Since it generates more cash than it can productively invest, it often returns some of that cash to shareholders through dividends.
The Choice Between Today and Tomorrow
Every company must decide what creates more value for shareholders. Should it distribute profits today, or should it reinvest those profits to earn even more in the future? Neither approach is automatically better. The right decision depends on whether the company can generate high returns by reinvesting its earnings.
When Reinvesting Creates More Wealth
Imagine your business earns ₹1 crore every year. If every rupee reinvested can generate even higher profits next year, paying a dividend may actually slow down the company's growth. This is why some of the world's best businesses have paid little or no dividend for many years while creating enormous wealth for shareholders.
When Cash in Hand Makes Sense
Some businesses have limited opportunities to grow further. Instead of allowing cash to pile up on the Balance Sheet, they distribute a portion of it to shareholders. Investors receive regular income while continuing to own the business.
Understanding Dividend Yield
Receiving a dividend is only half the story. Investors also want to know how meaningful that dividend is compared to the price they paid for the share. Dividend Yield answers that question by showing the annual dividend as a percentage of the current share price.
A Bigger Dividend Doesn't Always Mean Better Returns
Imagine two rental properties. One pays slightly higher rent but keeps losing tenants because the building is falling apart. The other pays slightly lower rent but keeps increasing in value every year. Focusing only on today's income without considering the quality of the asset can lead to poor decisions. The same applies to dividend-paying stocks.
Why Extremely High Dividend Yields Can Be Dangerous
A very high Dividend Yield may look attractive at first glance, but sometimes it happens because the company's share price has fallen sharply. The market may be worried about declining profits or an unsustainable dividend. A high yield is often a reason to investigate further, not a reason to buy immediately.
Can a Company Stop Paying Dividends?
Yes. Dividends are never guaranteed. If profits decline or the company needs cash for expansion, debt repayment, or difficult economic conditions, management may reduce or completely stop dividend payments. That's why investors should always look at the company's overall financial health rather than assuming dividends will continue forever.
Growing Dividends Tell an Interesting Story
Some businesses increase their dividend almost every year for decades. This usually reflects consistent profits, healthy cash flows, and disciplined management. Companies that can steadily grow both their earnings and dividends often become attractive long-term investments.
Where Does the Dividend Money Come From?
Dividends are usually paid from the profits earned by the business. However, what truly supports a dividend is cash. A company may report accounting profits, but if cash isn't actually flowing into the business, maintaining dividends becomes difficult over time.
Income Investors vs Growth Investors
Some investors prefer companies that pay regular dividends because they want steady income. Others prefer businesses that reinvest every rupee to grow faster, even if they receive no dividend today. Both approaches can be successful depending on an investor's goals and the quality of the business.
Looking Beyond the Dividend
Imagine someone offering you a fruit tree that gives you fruit every year, but the tree is slowly dying. Another tree gives you fewer fruits today but grows larger every year. A wise owner thinks about both current income and future growth. Great investing requires the same mindset.
Mistakes Beginners Often Make
Many beginners buy stocks simply because they have the highest Dividend Yield. They often ignore whether the company is growing, whether profits are sustainable, or whether the dividend can actually be maintained. A high dividend from a weak business is rarely a good investment.
Questions Every Investor Should Ask
Before investing for dividends, ask yourself: Is the company consistently profitable? Does it generate strong cash flow? Can it comfortably afford its dividend? Is management balancing growth and shareholder returns wisely? Is the business likely to keep increasing both its earnings and dividends over many years? The best dividend investments come from great businesses, not simply high yields.
INVESTOR PRINCIPLE