Dividends – the cash flow that you shouldn’t ignore

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 invariably 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 this towards general expenses.

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Karthik Rangappa

Vice President - Education & Research Services|Zerodha

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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 company ABC, what would happen if you use this money to buy more shares of ABC and thereby redeploy the dividend income back in your investment?

To get a general perspective on this 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 CNX Nifty and the Total Return Index.

As we know the benchmark CNX 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, CNX Nifty is often used as a benchmark for market performance. However, the CNX 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 besides capturing the capital appreciation in the market also captures the effect of dividend reinvestment. So think of the Total Return Index as the regular CNX Nifty along with the dividends.

The compounded average rate of return (CAGR) for Nifty over the last 3 years is about 11.2 percent.

However, the CAGR on the Total Return Index is 12.9 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 11.2 percent if you were to invest Rs 500,000 over 10 years period then you would generate a corpus of Rs 1,445,499 without reinvesting the dividends.

However, if you choose to reinvest the dividends you would make Rs 1,682,323, an additional Rs 236,823 over the same period. So the next time you see that dividend amount in your bank account does not ignore it. Redeploy the same for a better tomorrow.

Disclaimer: The author is VP, Educational Services, Zerodha. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.