Do all dividend paying companies make a good investment

There are two ways in which an investor can profit from his investment in stocks . First is through price appreciation, which we all know can remain depressed for a long duration even if the stock fundamentals are strong enough. Second way is to profit through dividends.

Dividends, unlike stock prices, do not depend on the whims and the fancies of the investor community at large. If the business is performing well and generating cash in excess of what is required for growth, dividends are generally paid out irrespective of the stock price movement .

As mentioned in an earlier article, a company can do two things with the profits that it earns. It can either invest it back into the company (into reserves and surplus) and/or pay out an amount as dividend. As such, dividend payout depends a lot on the cash (after meeting its capital expenditure and working capital requirements) or 'free cash' a company generates during a year. 

It quite often happens that many companies will not need to reinvest much into the business (in spite of having high return on investments), purely because their managements don't see the need for it. A classic example would be most of the companies from the FMCG sector. The FMCG sector is a slow yet steady growing industry. Most of the companies garner high return on their investments in this sector. But yet they choose to pay out huge dividends as growth levels are generally steady in nature and also because the capex requirements are on the lower side.

Now if we compare this to say a relatively fast growing industry such as telecom, the situation is quite different. We shall explain this with the help of an example. Telecom major, Idea Cellular has not paid any dividend till date since it is reinvesting the profits back into its business to roll out services across the country.

Do all dividend paying companies make a good investment?

The answer is understandably no. This is where the aspect of 'dividend yield' comes into picture. Dividend yield is calculated by dividing the amount paid out as dividend within a year by the company's share price. An example will help in understanding this better.

A company's stock is trading at a price of Rs 100 and during FY12 it has paid a dividend of Rs 5 per share in total. This stock would be having a dividend yield of 5% at the current price. Assuming that the company is growing steadily and is expected to pay dividends in the coming year, the investor could have surety of earning at least a 5% return on his investment.

However, it may be noted that one should not purely go out and buy a stock which has a high dividend yield as dividends are generally not fixed in nature. Therefore, understanding a company's growth plans, future capital requirement, expected free cash flow generation is important. It could be possible that a company may not be in a position to pay dividends or it might pay lower dividend in the future (as compared to earlier years) due to various reasons- an unprecedented loss, higher capex requirements, diversification into newer areas, amongst others.

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