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Opinion

Making Sense of Dividend Announcements

I write at Yahoo: Making Sense of Dividend Announcements:

“1860% dividend announced”, goes the headline. You’re excited. But the question isn’t, “Where do I sign?“, but “1860% is great, but a percentage of what?

The number is a percentage of “face value” which is as relevant today as a rotary-dial telephone. When a company is created, the founders distribute the initial capital into shares. A company started with Rs. 100,000 could be split into 10,000 shares of Rs. 10 each (the “face value” per share).

This company can, over time, earn enormous profits without any further capital requirements. Or, it might borrow money from a bank to fuel expansion and as it profits from growth. The capital could remain unchanged, with the original shares changing hands in a stock market. If the company grows to earn, say, Rs. 10 crore (Rs. 100 million) in profits, and decides to distribute half of it as profit, what happens?

You have a distribution of Rs. 5 crore (50 million) divided over 10,000 shares, or a dividend of Rs. 5,000 per share. The “face value” is still Rs. 10. So this is, effectively, a 50,000% dividend.

But the face value is irrelevant if you bought a share at Rs. 100,000 per share; for you, it’s a 5% dividend! The “50,000%” number has no significance.

Most companies insist — and some say there is a rule for it — on providing dividends as a percentage of face value. Mutual funds are mandated to provide both the value of dividend they offer (rupees per unit) and the percentage of face value which is usually Rs. 10.

For listed companies, a better way to represent dividend is the “yield” — or the percentage of the stock price). But there is a practical problem: the dividend is proposed (and announced) as a number per share, by the board, and approved at a general shareholder meeting a couple months later. And then, it takes another few weeks to actually pay out the money. In this time, the share price could have moved substantially away from the time when it was first announced. A Rs. 10 dividend on a stock priced at Rs. 500 is a 2% yield, but if the price moves down to Rs. 200 due to a global crisis before the dividend is paid, the yield is actually 10%.

The other problem is that face values are different. Some companies have a face value of Rs. 100, others “split” their face value down to Rs. 2 or Rs. 1. You have no idea what a “170%” dividend will mean if you don’t know what the face value is.

Some companies issue bonus shares, a process of converting retained earnings into share capital. So a 1:1 bonus will effectively double the number of shares in existence (each shareholder gets to double his holding). But since it’s the same company whose profit is now being distributed over a larger number of shares, the market price per share will go to half. If the company paid “100% of face value” as dividend earlier, it might only pay “50% of face value” today — yet, a shareholder will get the same amount!

The simplest way to represent a dividend is to state what percentage of profit is being paid out. A company making Rs. 10 per share as a profit could pay out Rs. 2 as dividend — the dividend distribution percentage is thus 20%. Even this has a disadvantage; since a company can pay dividend from both current and past profits, it might just turn out that some companies pay out 170% of their annual profits, which might confuse investors. (How do you pay out more than you earn?) But it is substantially better than the current “of-face-value” method.

Face value has lost relevance as companies in India have grown without the need to add more capital, and retained most of their earnings for future expansion. Paying out dividends means an extra dividend distribution tax, so companies will retain more profit back. Most times you won’t even know what the face value of a stock is — for instance, Infosys, which trades at a price of Rs. 2,500, has a face value of Rs. 5, while Reliance Industries (which trades at Rs. 735) has a face value of Rs. 10.

If you’d still like to chase a high number, Hero MotoCorp has just proposed a dividend of 2,250%. What that means: It’s a Rs. 45 dividend on a share that’s priced at Rs. 2,000+. You just can’t take dividend announcements at face value.

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