🌳 Dividend investing as a strategy: growth, safety and the traps

🎯 In 30 seconds: Dividend investing means choosing shares mainly for the cash they pay out. Two very different styles hide under the name: buying the highest yield today, and buying companies whose dividends grow over time. A high yield is often high because the price has fallen, and the payout may not last. The test that matters is whether the dividend is paid from free cash flow, not from borrowing. A dividend is not extra return: the share price drops by about the dividend on the ex-date. In India dividends are added to your income and taxed at your slab rate, and companies deduct TDS of 10% (20% without a valid PAN) once your dividends from one company pass ₹10,000 in a year.

What this chapter adds

Dividends, bonus issues, splits and buybacks explained the mechanics: record date, ex-date, interim and final dividends. This chapter is about using dividends as a strategy, and the mistakes that come with it.

Think of two mango orchards for sale. The first gives a big crop every year, but the trees are old and the owner has stopped planting. The second gives a smaller crop now, but the young trees bear more every season. Which one is the better buy depends on how long you plan to own it, and on whether the old trees will keep fruiting at all.

High yield or dividend growth: 20 years of numbers

The dividend yield is the annual dividend divided by the share price. A ₹100 share paying ₹4 a year yields 4%. Two hypothetical companies, both at ₹100 today:

• Old Orchard Ltd pays ₹7 a year (7% yield). Its business is not growing, so the dividend stays at ₹7 and the share price stays at ₹100.
• Young Orchard Ltd pays ₹2 a year (2% yield). Its profits and dividend grow 12% a year, and the share price grows at the same rate, so the yield stays at 2%.

The comparison is rigged in one way, and you should notice it: it assumes Young Orchard actually manages 12% growth for 20 years. Most companies do not. And it assumes Old Orchard's ₹7 never gets cut. Both assumptions are the real question. The numbers only show what is at stake if the growth or the payout fails.

Is the dividend paid for? The cash test

A dividend is paid in cash, so the place to test it is the cash flow statement, not the profit line. Three checks, all from the annual report:

1. Payout ratio = dividends ÷ profit after tax. Above 100% means the company is paying out more than it earned.
2. Free cash flow = cash from operations − capital expenditure. This is what is left to pay shareholders after keeping the business running.
3. Free cash flow cover = free cash flow ÷ dividends paid. Below 1 means the dividend is being paid from borrowing, cash reserves or asset sales.

Hypothetical Mehra Cement Ltd, from its last annual report:

A 75% payout ratio looks comfortable. The cash flow statement says otherwise. Look at the financing section: if borrowings rose by about ₹70 crore in the same year, the company borrowed to pay its dividend. One year can be a timing issue during a big expansion. Several years in a row is a dividend that is likely to be cut. The three financial statements shows where these lines are.

Also read the company's dividend distribution policy. Under the LODR rules, the top 1,000 listed companies by market value must have one on their website, stating the circumstances in which shareholders may or may not expect a dividend, the financial factors considered, and how retained earnings will be used. It does not promise a dividend, but it tells you what the board says it looks at.

Why PSU yields look high

Many government-owned companies (PSUs) have high dividend yields. Part of the reason is policy. The government is the main shareholder and receives most of the dividends. The Department of Investment and Public Asset Management (DIPAM) has guidelines for central public sector enterprises: as revised in November 2024, from FY 2024-25 they are expected to pay a minimum annual dividend of 30% of profit after tax or 4% of net worth, whichever is higher, subject to legal limits, with financial-sector PSUs allowed to use the profit measure alone. The 2016 guidelines used 5% of net worth.

What that means for you, as reasoning rather than a rule:

• A minimum payout rule supports the dividend, but it is a percentage of profit. If profit falls, the dividend falls with it.
• Many PSUs are in cyclical businesses such as metals, mining, oil and power. Their profits, and so their dividends, move with commodity prices and government policy on pricing.
• A high yield can also reflect a low price. The market may be pricing in slow growth, policy risk or the chance that the government sells part of its stake.

None of that makes a PSU a good or bad investment. It means a PSU's yield needs the same cash test and the same look at its business cycle as any other company. Sectors and the business cycle covers PSU stocks.

Yield on cost, and why it can mislead

Yield on cost = today's dividend ÷ the price you originally paid. In the example above, Young Orchard bought at ₹100 pays ₹17.23 in year 20: a 17.2% yield on cost. It feels great, and it tells you the dividend grew. But it is not a reason to keep holding. The decision that matters is whether ₹965, the share's value today, is better kept in this company or elsewhere. Today's yield on that ₹965 is still 2%.

A dividend is not extra return

When a company pays a dividend, cash leaves the company and arrives in your bank account. The company is worth less by that amount, so on the ex-dividend date the share price usually falls by about the dividend, give or take the day's other news.

Total return is what counts: price change plus dividends. A company that keeps its cash and reinvests it well can create more value than one that pays it out. A company that pays out cash it cannot use well is doing you a favour. Dividends are one way of getting returns, not an addition to them. Buying a share just before the record date "to catch the dividend" does not make money by itself, because the price adjusts and you then owe tax.

Taxes, TDS and reinvesting

Since the Budget 2020-21 removed the dividend distribution tax, dividends have been taxed in the shareholder's hands. They are added to your income and taxed at your slab rate, whatever the size. As of October 2026, under the Income-tax Act, 2025:

• A company deducts TDS of 10% from dividends paid to a resident individual, or 20% if you have not given a valid PAN.
• No TDS is deducted if your dividends from that company in the financial year total ₹10,000 or less (the threshold was ₹5,000 before the Budget 2025-26 raised it). The dividend is still taxable.
• TDS is not the final tax. It shows against your PAN, and when you file your return you pay the balance if your slab is higher, or claim a refund if your total tax is lower.

Example: you receive ₹15,000 from one company. TDS of ₹1,500 is deducted and you receive ₹13,500. If you are in the 30% slab, you owe a further ₹3,000 when you file (plus any cess and surcharge). If your total income is below the taxable limit, you can claim the ₹1,500 back. Taxes for traders and investors covers the wider rules; ask a CA whether you can file a declaration so that no TDS is deducted when your income is low.

Two comparisons follow from this, as reasoning:

• For someone in a high slab, tax on dividends can be higher than tax on long-term capital gains on listed shares, which are taxed at a separate rate. For such an investor, a company that reinvests or buys back shares can be more tax-efficient than one that pays out, all else equal. Buyback proceeds have been taxed as capital gains from 1 April 2026, with an extra tax for promoters.
• For someone with little other income, dividends may attract little or no tax, and the TDS can be claimed back.

On reinvesting: Indian companies pay dividends in cash to your bank account. If you want to reinvest, you buy more shares yourself, paying brokerage and charges. Mutual funds offer a choice between a growth option, which keeps the income inside the fund, and an income distribution option. Mutual funds, index funds and ETFs explains the difference. Check the tax effect with a CA if the amounts are large.

Try it

1. Pick two listed companies with very different dividend yields, one above 5% and one below 2%. For each, open the last three annual reports on NSE or BSE.
2. For each year, note profit after tax, dividends paid, cash from operations and capital expenditure. Compute the payout ratio and the free cash flow cover.
3. Note the change in borrowings each year from the cash flow statement.
4. Find each company's dividend distribution policy on its website. Write one sentence on what it says shareholders can expect.
5. Look up each share's price five years ago and today. Add the dividends paid per share over the period. Which gave the higher total return?

Sources

• Government of India: Budget 2020-21 speech, removal of Dividend Distribution Tax
• Government of India: Budget 2025-26 speech, TDS threshold on dividends raised to ₹10,000
• Government of India: Budget 2026-27 speech, buyback taxed as capital gains
• PIB: Income Tax Act, 2025 to come into effect from 1 April 2026
• SEBI: LODR Regulations, 2015, Regulation 43A (dividend distribution policy)
• Example CPSE dividend distribution policy (December 2024) quoting DIPAM's revised capital restructuring guidelines