Dividend Yield Factor

Saturday morning a cousin forwards me a screener. Thirty stocks sorted by dividend yield, highest first, with a caption that said "passive income portfolio." He had already picked the top five. I asked him one question. Why is the yield high.

He had never thought about it. Most people never do. A fat yield looks like a reward, like the company is paying you to hold it. What it actually tells you is how cheap the stock is, and cheap is not the same thing as generous.

Dividend yield is a fraction. The numerator gets all the attention. The denominator is doing all the work.

A five percent yield from two different planets

Here are two stocks sitting side by side on a screener. Both show a five percent yield. The screener treats them as equals. They are not.

Stock X was trading at a thousand rupees a year ago. The business wobbled, guidance disappointed, the price fell forty percent to six hundred. The company still pays its thirty rupee dividend. Yield: thirty divided by six hundred, five percent. The yield is high because the price crashed.

Stock Y has been steady near six hundred for years. It raised its dividend from fifteen to thirty over three years, doubling the payout as earnings grew. Yield: thirty divided by six hundred, five percent. The yield is high because the dividend grew.

A screener that sorts by yield ranks these two equally. One is a beaten down stock whose price has done most of the talking. The other is a business that earned its way to a higher payout. The screener does not know the difference. The denominator does.

The research says the return was never the dividend

This is not a guess. The Financial Planning Association published a study that pulled apart decades of high dividend yield returns and tested where the outperformance actually came from. The finding: it was the value factor inherent in high yield stocks that drove the returns. The yield factor itself, the part everyone was chasing, actually detracted from performance.

Read that again. The piece everybody pointed at as the reason to buy was quietly dragging the portfolio down. The piece nobody noticed, the cheapness of the stock, was the engine.

Fama and French documented in 1988 that dividend yields forecast stock returns, and the forecasting power increases with the return horizon. But the mechanism runs through the price, not the dividend. A high yield signals a low price relative to fundamentals, which is what value investing has always been.

Ned Davis Research tracked US stocks from 1973 onward and found the highest yielding quintile actually trailed the broad market by about a percentage point a year. Wellington Management ran an even longer window, 1930 to 2024, and found the second quintile, the moderate yielders, outperformed the fattest yielders by two to three points a year.

The stocks that grew their dividends steadily finished at 8.8 times the starting capital. The stocks with the fattest yields finished at 6.1 times. Same two decades. The grower cohort beat the highest yield cohort by nearly Rs 27 lakh on the same ten lakh. The fat yield was never the signal. The growth underneath it was.

Same six percent yield, three completely different businesses

This is where the screener breaks down hardest. Dividend yield has a simple identity that nobody puts on the brochure.

Dividend yield equals the payout ratio multiplied by the earnings yield. Payout ratio is how much of its profit a company sends out. Earnings yield is the inverse of the P/E. So the yield is a mix of two inputs and you cannot read one without knowing the other.

Three companies, all showing a six percent yield.

Source . illustrative . DY = payout ratio times earnings yield

The third company, at a P/E of five, is priced like something is broken. It barely pays anything out and still shows a six percent yield because the price is that low. The second company has to pay out eighty percent of its earnings to reach the same number, which leaves very little to reinvest. Same screener column, three businesses with nothing in common except the fraction the screen happens to compute.

A screener cannot tell you which of these three is a compounder, which is a fair hold, and which is a value trap about to cut its dividend and watch the yield evaporate. The number is doing its job. Your job is to read what produced it.

India made the tax case worse in 2020

Until March 2020 dividends in India were effectively tax free for the shareholder. The company paid a Dividend Distribution Tax of roughly twenty percent, and the investor received the full amount without any further deduction. For a top slab earner especially, dividends were the cheapest form of return.

The Finance Act 2020 flipped that. DDT was abolished from 1 April 2020. Dividends are now taxed in the hands of the shareholder at their income tax slab rate. A thirty percent slab investor with four percent health and education cess pays an effective 31.2 percent tax on every rupee of dividend. A Rs 40,000 annual dividend that used to arrive whole now leaves Rs 27,520 after tax.

A hundred rupees of profit paid as a dividend to a top slab investor arrives as Rs 68.80. Reinvest that at twelve percent for ten years and it grows to about Rs 214. The same hundred rupees left inside the company, compounding at the same rate, grows to Rs 311. Sell and pay LTCG of 12.5 percent and you keep Rs 284.

The retention path finishes thirty three percent ahead. Same profit, same growth rate, same investor. The only variable is the route. Dividend taxation hits every year. Capital gains tax waits until you sell. That deferral is worth more the longer you hold, and it widens every year the money compounds untaxed inside the company.

Where this breaks, and the honest half

A company sitting on cash it cannot reinvest above its cost of capital should return it. A dividend in that case is not a leak, it is a discipline, forcing the business to hand back what it would have wasted on bad acquisitions or vanity projects. The dividend payout anchors management to the cash the business actually generates, and that accountability has value.

The highest yield cohort also includes mature, stable businesses with limited reinvestment needs. Utilities, for instance, pay out heavily and compound slowly, and that is a feature for an investor who needs current income. Yield is not a flaw for someone living off the portfolio. It is a requirement.

What the research does not say is that dividends are bad. It says that sorting by yield and buying the top of the list is buying a value factor in disguise, often capturing the beaten down names right before a dividend cut, rather than the compounders that earned their way to a higher payout. The distinction between a high yield from a falling price and a high yield from a growing dividend is the entire story, and no screener column shows it.

Three things I keep coming back to

Read the denominator before the numerator. A yield of six percent from a P/E of five is a different animal from six percent at a P/E of thirteen. The fraction hides the cause. Ask what produced it before you act on it.

Growers beat yielders. The cohort that steadily raised its dividend, funded by growing earnings, outperformed the cohort with the fattest yields. The payout is the receipt, the earnings growth is the engine. Own the engine.

Tax is a return you hand over every year. Since April 2020 a top slab Indian investor pays 31.2 percent of every dividend. A capital gain pays 12.5 percent once, years later. The gap compounds quietly and finishes a third ahead on the same hundred rupees. A fat dividend is a generous tax bill dressed as income.

The screener sorts by yield. The return comes from what is underneath it. If you want to understand what drives the return in your own portfolio, start with a risk profile and read the fraction, not the number.