Financial Markets & Institutions

Dividends Yields
Vs

Capital Gains

By
Harsh Shah
 Table of Contents
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1 Title 1

2 Defining Dividends Yields and Capital Gains 3

3 Advantages and Disadvantages of Investing in Stocks for Dividends 4
4 Advantages and Disadvantages of Investing in Stocks for Capital Gains 6
5 Taxation of the Stocks 8
6 Companies with High Dividend Yields 9
7 Companies with High Capital Gains 14
8 Final Verdict 15
9 References 16

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Defining Dividend Yields and Capital Gains

 Dividend Yields

A dividend is a reward given to shareholders who have invested in a company's equity,

usually originating from the company's net profits. Companies keep most profits as retained
earnings, representing money to be used for ongoing and future business activities. However,
the rest is often given out to shareholders as a dividend. A company's board of directors can
pay out dividends at a scheduled frequency, such as monthly, quarterly, semi-annually, or
annually. Alternatively, companies can issue nonrecurring special dividends individually or
in addition to a planned dividend.

As an example, consider an investor who bought 500 shares of stock in company XYZ at Rs
5 per share, for a capital expenditure of Rs 2,500 (500 x Rs 5 = Rs 2,500). Regardless of the
movement in the price of the stock, the investor benefits if company XYX announces a
special dividend of Rs 0.10 per share (2% dividend yield). In this case, the investor has
dividend income of Rs 50 (500 x Rs 0.10).

 Capital Gains

A capital gain is an increase in the value of a capital asset such as a stock or real estate that
gives it a higher value than the purchase price. An investor does not have a capital gain until
an investment is sold for a profit. By contrast, a capital loss occurs when there is a drop in the
capital asset value versus an asset's purchase price. An investor does not have a capital loss
until selling the asset at a discount.

As an example, consider company XYZ, previously mentioned. Suppose that the shares rally
to Rs 7 each, making the total value of the investment rise to Rs 3,500 (500 x Rs 7 = Rs
3,500). If the investor sells the shares at market value, the ending capital is Rs 3,500. The
capital gain on this investment is then equal to the ending capital minus the initial capital, for
a capital gain of Rs 1,000 (Rs 3,500 - Rs 2,500 = Rs 1,000).

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Advantages and Disadvantages of Investing in Stocks for Dividends

Advantages

1. Periodic Returns

As mentioned earlier, shareholders of dividend stocks earn dividends on their shares at

regular intervals. Also, such companies retain a considerable portion of their revenues as
reserves which allows them to continue paying periodic dividends even through a market
slump, ensuring consistency in dividend pay-outs.

2. Minimal Risk

Dividend stocks carry nominal risk when compared to other market-linked financial
instruments. This can be attributed to a stable financial and operational infrastructure of
large cap companies to maintain dividend payments, even during market downtrends.
Additionally, the prices of such shares remain relatively stable over time. Hence, investors
do not run the risk of losing their capital or bearing loss on dividend yield stocks.

3. Inflation-Adjusted

Businesses that issue the best dividend yield stocks are usually market leaders; hence, they
have a competitive advantage in the market allowing them to regulate the prices of their
products at par or above the inflation rate. Resultantly, they can also afford to distribute
dividends which are in tandem with inflation in the economy.

Disadvantages

1. Low Capital gains

Dividend stocks do not lead to capital gains for investors, as the unit stock values of
such large-cap companies do not demonstrate fluctuations of high degree with
variations in the stock market. Thus, such shares are not suitable for short-term
investment goals, as price variations between such timespan are nominal.

2. Expensive

Shares associated with routine dividend pay-outs are mostly issued by large-cap
companies such as industry giant businesses and multinational corporations. Securities
issued, consequently, are of substantial value. Also, since most people tend to hold on to
such shares after acquiring them, finding a seller in the market may prove to be
challenging.

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 3. Not assured

Dividend pay-outs are not mandatory, and are announced by the company when it
generates substantial profits for any given year. Nonetheless, the management can
decide upon not distributing accrued gains among shareholders in this respect to
increase the retained earnings base for business development and expansion purposes.

4. Limited growth opportunities

Large-cap companies are primarily responsible for issuing dividend stocks, as they have
the resources to undertake large scale production and distribute corresponding earnings
among shareholders, without retaining a substantial portion for reinvestment. However,
widespread growth opportunities are limited for such companies, owing to their
substantial market presence. As a result, the dividend payable is likely to be steady
during extended periods, subject to minor changes through further expansion.

Who should invest in dividend stocks?

Equity shares distributing substantial dividends periodically are ideal for investors
looking for long term investment options, wherein the security of corpus is crucial.
Novice investors looking for alternatives to earn higher returns through the stock market
can choose to include such shares in their portfolio.

Additionally, experienced investors looking to dilute the risks involved can allocate a
portion of their total investment portfolio to purchase such shares. This helps them
enjoy a steady income through routine dividend pay-outs even during times of distress
in the stock market causing losses through other riskier investments.

Thus, if you have just started investing in the stock market, and are looking for reliable
investment options, or want to mitigate risks associated with such investments in the
share market, opting for dividend stocks is an attractive option. Nonetheless, as such
investments have to be kept locked in for an extensive period to realise adequate profits,
make sure the proportion of money you invest in dividend stocks suits these criteria, and
hence, is not required for fulfilling any short-term requirements. Going through the
financial statements of companies and history regarding dividend payments and
corresponding market reputation will help you identify such businesses with ease.

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Advantages and Disadvantages of Investing in Stocks for Capital Gains

Advantages

1. Takes advantage of a growing economy

As the economy grows, so do corporate earnings. That's because economic growth creates
jobs, which creates income, which creates sales. The fatter the paycheck, the greater the boost
to consumer demand, which drives more revenues into companies' cash registers. It helps to
understand the phases of the business cycle - expansion, peak, contraction, and trough.

2. Best way to stay ahead of inflation

Historically, stocks have averaged an annualized return of 10%.1 That's better than the

average annualized inflation rate. It does mean you must have a longer time horizon. That
way, you can buy and hold even if the value temporarily drops. 

3. Easy to buy

The stock market makes it easy to buy shares of companies. You can purchase them through
a broker, a financial planner, or online. Once you've set up an account, you can buy stocks in
minutes. Some online brokers such as Robinhood let you buy and sell stocks commission-
free.

4. Make money in two ways

Most investors intend to buy low and then sell high. They invest in fast-growing companies
that appreciate in value. That's attractive to both day traders and buy-and-hold investors. The
first group hopes to take advantage of short-term trends, while the latter expect to see the
company's earnings and stock price grow over time. They both believe their stock-picking
skills allow them to outperform the market. Other investors prefer a regular stream of cash.
They purchase stocks of companies that pay dividends. Those companies grow at a moderate
rate.

5. Easy to sell

The stock market allows you to sell your stock at any time. Economists use the term "liquid"
to mean you can turn your shares into cash quickly and with low transaction costs. That's
important if you suddenly need your money in a hurry. Since prices are volatile, you run the
risk of being forced to take a loss.

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Disadvantages

1. Risk

You could lose your entire investment. If a company does poorly, investors will sell, sending
the stock price plummeting. When you sell, you will lose your initial investment. If you can't
afford to lose your initial investment, then you should buy bonds. You get an income tax
break if you lose money on your stock loss. You also have to pay capital gains tax if you
make money.

2. Stockholders paid last

Preferred Shareholders and bondholders/creditors get paid first if a company goes broke. But
this happens only if a company goes bankrupt. A well-diversified portfolio should keep you
safe if any one company goes under.

3. Time

If buying stocks on your own, you must research each company to determine how profitable
you think it will be before you buy its stock. You must learn how to read financial statements
and annual reports and follow your company's developments in the news. You also have to
monitor the stock market itself, as even the best company's price will fall in a market
correction, a market crash, or bear market.

4. Emotional roller coaster

Stock prices rise and fall second-by-second. Individuals tend to buy high, out of greed, and
sell low, out of fear. The best thing to do is not constantly look at the price fluctuations of
stocks, just be sure to check in on a regular basis.

5. Professional competition

Institutional investors and professional traders have more time and knowledge to invest. They
also have sophisticated trading tools, financial models, and computer systems at their
disposal.

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Taxation of the Stocks

Two types of tax are levied on dividend stocks – Dividend Distribution Tax (DDT) and
capital gains taxes. The Dividend Distribution Tax is paid by the company that is
distributing the dividend, on behalf of such shareholders. In other words, investors receive
their dividends after DDT has been deducted from it.

Currently, a 15% DDT is levied on dividends along with surcharge and cess, which
effectively brings up the tax rate to 20.56%. Other than DDT, investors that have dividend
earnings over Rs. 10 lakh are required to pay an additional 10% tax on their dividend
income.

Capital Gains Tax is paid on the profit which investors earn upon selling stocks in the
market. If dividend yield stocks are sold before 12 months of holding it, a 15% short term
capital gains tax is levied on such capital profits. On the other hand, if an investor sells
their dividend stocks after 12 months of holding it, they need to pay a 10% tax on
their long term capital gains tax if such profits exceed Rs. 1 lakh.

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Companies with High Dividend Yields

1. Coal India

Following table shows the Dividend Yield % for the last 5 years:

Following table shows the profitability ratios of Coal India

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 2. Hindustan Zinc

Following table shows the Dividend Yield % for the last 5 years:

Following table shows the profitability ratios of Hindustan Zinc:

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 3. ONGC

Following table shows the Dividend Yield % for the last 5 years:

Following table shows the profitability ratios ONGC:

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 4. Power Grid Corporation of India Ltd.

Following table shows the Dividend Yield % for the last 5 years:

Following table shows the profitability ratios of Power Grid Corporation of India:

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 5. ITC

Following table shows the Dividend Yield % for the last 5 years:

Following table shows the profitability ratios of ITC:

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Companies with High Capital Gains

Following table shows the companies with their price difference between February 2016 to
February 2021 with the percentage change:

The above companies are in an descending order with maximum capital gains (%) to
minimum capital gains (%). The table has top 12 companies. It can be seen that these
companies are giving staggering returns when it comes to capital gains.

Let us now consider the top companies which we analysed to understand the dividend yields.

Major question remains: Are those companies able to provide such returns?

The above table is the perfect example to understand the advantages and disadvantages of
capital gains. Higher the risk, higher is the reward.

Final Verdict

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As we studied the top companies for dividend yield (also the capital gains of the same
companies) and the top companies for capital gains, the difference is staggering. Though
relying on capital gains can be risky to some extent, doing fundamental research about the
company, company’s management as well as the industry will help in taking a calculated risk.

The ideal dividend yield percentage is 2% to 6%. On top of that, it completely depends on the
company whether they want to distribute dividends. Therefore, investing just for the
dividends is not the best option according to me. Companies with solid fundamentals can
help in extremely high percentage returns (comparatively) through capital gains.

Therefore, according to me, investors should invest for the capital gains.

References:

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 1. https://www.investopedia.com/ask/answers/033015/there-difference-between-capital-
gains-and-dividend-income.asp

2. https://www.cnbctv18.com/personal-finance/here-are-the-pros-and-cons-of-investing-
in-dividend-paying-stocks-5110561.htm

3. https://www.thebalance.com/stock-investing-for-the-individual-investor-3306182

4. https://www.tickertape.in

5. https://www.moneycontrol.com

6. https://www.equitymaster.com/stock-markets/13/14/0/nse-nifty-gainers-over-5-years

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