Monday, January 31, 2011

6 Things You Have to Know about Dividends and Capital Gains


Investors earn from investing in the stock market in two ways: first, by receiving periodic cash payments called dividends; second, by selling stock at a price higher than the purchase price, with the price difference being referred to as capital gain.

Here are some important things that you have to remember about dividends and capital gains.

1. Dividends tend to be more reliable than capital gains. If a firm has been paying 1 peso per share dividend per year in the last 10 years, it's highly likely that it will continue to pay this amount (or higher) in the foreseeable future. Capital gains, on the other hand, are highly unpredictable because of the inherent volatility of stock prices.

2. Dividend payments are announced several weeks before they are due. You can ask your broker to send you notices of dividend declarations, or check out the PSE website for such announcements (here is the last dividend declaration from Meralco (MER)).

3. To be entitled to dividend payments, you should own the stock on or before the ex-date. In the case of Meralco above, you should have owned the MER stock on December 22, 2010 at the latest to receive the 1.30 peso per share dividend. And yes, it's possible to own the stock for only one day and still receive the dividend.

4. In computing for the total percentage return, or proportional increase in value, of your investment, consider both dividends and capital gains, and all relevant taxes and fees. To illustrate how this computation works, here's an example of a recent stock transaction I made here in Hong Kong.

I bought 100 shares of the Hang Seng Index ETF (stock code 2833) at 233.20 HKD on October 29, 2010, and sold the shares at 243.60 HKD on January 14 of this year.

As you see, total buying and selling costs can be quite considerable, in this case around 1.2% of my investment.

A dividend of 2.60 HKD per share was announced a few weeks after the purchase, with an ex-date of December 17, 2010. Since I owned the stock up to the ex-date, I was entitled to receive dividends for my shares.

We can compute for the total return of my investment (total % return) using the following approach:

So I earned 4.34% or 1,017.18 HKD (230 HKD in dividends and 787.18 HKD in capital gains) on my 77-day investment. It may not be good enough for some of you, but it's definitely good enough for me.

5. Total % return = dividend yield + capital gains yield, where

I'll let you work out the math for the example above. You should get a dividend yield of 0.98% and a capital gains yield of 3.36%.

Unlike in the example, in practice, dividend yields are quoted on a per-year basis and excludes taxes and transaction costs. Since dividends are usually paid twice a year, the dividend yield quotes you see on websites like Google Finance and Bloomberg include both payments. 

6. In most cases, especially if your investment is not big enough, dividends won't be enough to cover taxes and transaction costs (in the example, 1.2% in costs vs. a 0.98% dividend yield), so in deciding when to sell your shares, you have to make sure that you have enough capital gains to provide you the return that you're aiming for, net of all costs.
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