Why understanding how dividend yield works is important

 Reinvesting dividends could significantly improve your earnings from stocks portfolio.

Photo credit: Shutterstock

Managing Director Canaan Capital Limited

Is it prudent to allow companies to make payouts to shareholders? Some people say money paid to shareholders is no longer available to pay creditors. That payments reduce any company’s ability to absorb losses without becoming distressed. Yet, others believe payouts are often triggers to great momentums.

And have we noticed the current momentum fizzling out lately? Why do we care? Well, if momentum stocks are bought solely for their positive price momentum, it also follows that once they lose that momentum, the principal reason for buying them in the first place disappears.

And perhaps this shows its weakness - the risk that momentum selling evolves into more selling, which ultimately leads to something potentially more problematic than a ‘healthy internal market correction. It makes the whole concept of momentum somewhat nebulous, given that it describes not a business model or even a set of balance sheets or other financial characteristics but rather simply a price phenomenon – the tendency to keep going up.But enough of momentum strategies. What do you do to escape the funk? Time to give shares of dividend-paying companies a second look. The volatile share market has indeed boosted the appeal of dividend stocks as investors have sought to buttress their portfolios against stubborn inflation and a sideways market.

There are currently over 13 stocks at the Nairobi Securities Exchange (NSE) spotting dividend yields above 10 percent. The NSE 20 Share index is paying a dividend yield of 7.8 percent overall, while some well-known dividend payer is paying dividend yields of 17 percent, compared with the 16 percebt yield of the 364 treasury.

If one goes further and adds the advantage of the power of compounding, reinvesting your dividends - rather than cashing them out - they can significantly boost their returns, which is another reason why understanding how dividend yield works is so important.

Of course, not all investors will be convinced that dividends are the best source of income. However, the strategy makes sense as it focuses on stable firms with growing cash dividends that offer protection against volatility and also against inflation. Some of the listed tier-one banks are among the stocks that have lately touted dividend-paying stocks and most have notched positive net share inflows year to date.

But other sectors are also well represented. Also look out for companies that are poised to increase their dividends as they may serve as a steadier source of income than bonds, which have a fixed coupon that can be eroded by rising prices. With little end to the volatility in markets in sight, it doesn’t hurt to look at stock dividends to help stabilise your portfolio returns.

Note: A high dividend yield can be appealing since one is getting more income per shilling invested, but a high yield isn't always a positive thing. It could mean that the company’s stock price has been falling or dividend payments have been increasing at a higher rate than the company’s earnings.

To make sure your investments are sound for the long-term, look at dividend yield as part of the big picture, alongside other metrics like company fundamentals.

Mwanyasi is MD, Canaan Capital.