What does one mean by Dividend Yield and when is this concept relevant in equity investing

The term dividend yield refers to the ratio of total annual dividend a company pays out in dividends each year relative to its share price.

The corporate earnings of the company get distributed amongst its shareholders. Dividend is distributed as the fixed amount per share in proportion to the companys shareholding. Dividend is paid on face value out of the retained earnings of the company.

Another long term benefit of investing in high dividend paying stocks is that dividend income is tax free in the hands of investors. The concept is, since a listed Indian company paying dividend is supposed to pay dividend distribution tax, investors earning that dividend do not need to pay income-tax

In recent times, high interest rates, inflation and slower income growth have resulted in a demand squeeze in the economy, hurting manufacturing. In such a scenario how does one relate this parameter when investing in stocks ?
Dividend Yield as a parameter by nature cannot be used in growth phase of the markets as investors then look at growth and are willing to risk capital for higher growth expectations.

Hence this ratio is often used by investors in uncertain markets where growth takes a back seat. It is at this time when this parameter is used by investors to get in to blue chip stocks where dividends are attractive and where consistency is very important.

The basic categorization for an investor is whether the company he selects for dividend yield purpose is at a growth stage or maturity stage. A growing company will not pay high dividends to its shareholders. Instead it will retain the earnings to deploy into newer projects, expansion potentially leading to a higher share price in the future.

On the other hand a matured or well established company will pay higher dividends.The dividend yield might differ from sector to sector. Mostly industrial and consumer goods sectors might pay lower dividends than Infra and healthcare sectors. This is because capital intensity is far higher in Pharma and Infra sectors and hence there is a greater need to conserve profits and plough them back in the business rather then giving back high dividends to shareholders.

What does one need to look in general to select good quality dividend yield stocks? Some of the basic requirements according to us (Niveza Research) would be that the company selected should have the following attributes.

1. First such a company must have a five year track record for dividends paid
2. The track record of the managements running the company should be clean with no corporate governance issues.
3. Dividends policy of companies (Atleast 30% of the PAT should be paid as dividends)
4. The business model of the company paying dividends should not be vulnerable to govt policies or concentration on a handful of cuistomers.
5. Institutional Ownership in the company over the last 5 years should see a rising trend.
6. Overall Debt position of the company should be minimal or reasonable as compared to the networth on the balance sheet.

Many cash rich corporate enjoy a strong track record of regular dividend payments. Hero MotoCorp is one. The motorcycle maker has paid dividends anywhere between Rs 45 and Rs 110 a share in the last four financial years.
VST Industries, a manufacturer of cigarettes and tobacco products, has been paying out Rs 45-65 a share in the past three years.

Glaxo Pharma, Page Industries (it has announced Rs 44 in dividend in the first nine months), Nestle (Rs 36 a share this year), Pfizer, Bosch, ACC and Eicher Motors are some of the firms that have records of consistent dividend payment.
The board of GlaxoSmithKline Pharma has recently recommended a final dividend of Rs 50 per share for the year ended December 31, 2013. However investors should not chase stocks solely on the basis of dividend yields. They must also look at the growth prospects of such companies.

Technically by distributing large dividends means that a company is allocating lesser funds towards expansion or inorganic growth, which may put the business at the risk of stagnation once it reaches a point of saturation or hits the end of a business cycle. However MNC companies have a different reason for distributing higher dividends as they have to pay higher dividends to remit a large portion of their income back to their parent firms.
The Dividend Trap:

Before one selects any company for dividend yield purposes it is very important and to be clearly aware whether it is currently going through any cyclical industry related problems or suffering from any business slowdown may which can keep the dividend payout artificially high despite dwindling profits to keep investors bullish on the stock.
Also it is important that dividends are being paid out of operating profits, and not out of exceptional income.
Ultimately the winning strategy to ensure that the Dividend Yield parameter works optimally for an investor is that the company offers a healthy mix of capital growth and reasonably good dividend payout ratio.

Good amount of attention to earnings growth prospects, consistency in return on equity, industry outlook and management plans can also help investors get good opportunities in stocks using this parameter.