How Banks Decide Dividends

A bank’s board decides on dividends after factoring in profits, capital requirements and plans for growth. Since the latter is a regulator’s concern, lenders are not free to distribute all their earnings. Growing financial institutions tend to keep more of their profit to fund loans, while mature ones release a larger amount for the benefit of shareholders.

The regulator also has a say. The state is concerned that banks maintain adequate capital norms and meet specific criteria set out for declaring dividends. Such caution helps protect depositors’ interests, limiting the ability of banks to pay out freely–in some cases, one year could see payouts and the next none.

Yield Versus Growth

Dividend yield, which is the ratio of an annual dividend to the market price of a share, is often low for large banks–sometimes even under two per cent. For income-conscious investors, it is wise to focus on other sectors. But one should be wary of chasing yield. Earnings that are not disbursed can be reinvested to add to the book value, which in turn raises the stock price.

A bank that makes a return on equity of fifteen per cent and is retaining most of its earnings can make the shareholder richer–much richer–over a long time frame. It is the total return, the combination of price appreciation and dividend, that matters.

The Mathematics of Reinvestment

Imagine that you get a dividend every year and decide to reinvest it back into the bank. Because you have more shares, next year’s instalment will be larger, and so on. After a decade of regular payouts, you’ll be surprised as to how much income this single act of yours would have generated–especially if this bank happens to be raising its payout every year. It takes discipline rather than skill to accumulate wealth through the regular compounding of dividends. Not only does the method ensure you are investing during a dip, buying more shares when the market price is low, by its very nature–it averages your purchase price.

Tax Treatment in India

Dividend income is taxable in the hands of the shareholder at the applicable slab rate and tax may be deducted at source beyond certain thresholds. Profits on shares are subject to tax at varying rates depending on how long you hold them. Tax laws are modified periodically and therefore it is wise to check on the most recent provisions or consult a chartered adviser while structuring payouts.

Keeping records of dividends received and dates of purchase make matters easy while calculating tax liabilities as well as claiming benefits.

Signals Hidden in Payout Patterns

Consistent or regularly rising dividends tend to indicate that management’s believes that its earnings outlook and capital structure will remain stable. A cut in payouts could be indicative of stress. On the other hand, an unexpectedly rich payout, from a bank that is facing asset quality issues, should be taken with a pinch of salt. Always look at the dividend, as an ancillary to capital adequacy, profit growth and provisioning. Sustainable income is generated from earnings, not balance sheet.

Building a Compounding Plan

Buy names that have credible franchises, reasonable asset quality and fair valuation. Decide on how big you want your banking exposure to be. Invest regularly, it helps to have regular income to fund buys, and you should stick to a systematic schedule. In the first year, you’ll see the number of shares rise as will the payouts. Compare this to a fixed deposit or the return from a debt fund. Banking equities are volatile but have in the past, richly rewarded patience and careful choice. The mathematics of such compounding can make your friend – all you need to do is to stay the course.

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