Dividends are paid to distribute the profits made by the company during the year. Dividends are paid on a per share basis to all the shareholders of the company.
By Karthik Rangappa
When you invest in Equities you generally do so for capital appreciation, wherein you expect the stock price to go higher than your original investment price. But, then besides capital appreciation, there is also an income in the form of a dividend.
Dividends are paid to distribute the profits made by the company during the year. Dividends are paid on a per share basis to all the shareholders of the company. Dividends are usually credited directly to your Bank account from the company paying out the dividend.
As you may know, the dividend yields are quite low, sub 4 percent in most of the cases. Since the dividend yields are low, we somehow tend to ignore this cash flow and we end up using the dividend amount towards general expenses.
Now, what would happen to the return on investment, if you were to reinvest the dividends back into the same stock?
For example, if you receive Rs 10,000 as dividends from Infosys, what would happen if you use this money to buy more shares of Infosys and thereby redeploy the dividend income back on your investment?
To get an answer for this question we can look at the “Total Return Index” (TRI). However before we discuss TRI, we need to understand the difference between the regular index such as Nifty and the Total Return Index of Nifty.
As we know Nifty represents a basket of 50 stocks. The increase or decrease in the index value gives a rough estimate of the overall capital appreciation in stocks. For this reasons, Nifty is often used as a benchmark for market performance.
However, the Nifty captures only the capital appreciation from equity investments and does not consider the dividend cash flow. This is where Total Return Index comes into play.
The Total Return Index of Nifty besides capturing the capital appreciation in the market also captures the effect of dividend reinvestment. So think of the Total Return Index as Nifty plus the dividends received.
The compounded average rate of return (CAGR) for Nifty over the last 3 years (June 2014 to June 2017) is 9.45 percent. However, the CAGR on the Total Return Index is 10.8 percent. A difference of 1.35 percent.
While the percentage difference seems small, do remember this is a compounded return, and it does make a difference over a long period. To give you a perspective, at the given rate if you were to invest Rs 500,000 over 10 years period then you would make Rs 1,233,649 without reinvesting the dividends.
However, if you choose to reinvest the dividends you would make Rs 1,394,678, an additional Rs 161,029 over the same period. So the next time you see that dividend amount in your bank account do not ignore it. Plough it back for a better tomorrow.Disclaimer: The author is VP, Educational Services, Zerodha. The views and investment tips expressed by investment experts on moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.