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This article appeared in the May 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

How dividends and interest rates affect share prices and yields.

From Morningstar

The sharemarket can rise more strongly than traditional fixed-interest investments such as bonds and cash. Although that is not always the case, it is a principle that usually holds true over long periods of time. Shares sound a bit more exciting than fixed interest, and where there is more excitement you will nearly always find more risk.

The key points in this article are:

  • Dividend payments can rise or fall from one year to another, so shares offer less certainty than more traditional investments, such as fixed income.
  • Investors demand a greater return from shares to compensate for this uncertainty.
  • Changes in dividend payments are likely to drive share prices up or down.
  • Changes in interest rates are likely to drive share prices up or down.
  • Share prices often move in anticipation of changes in dividends and interest rates, which mean that by the time a company has announced a rise in dividend, the good news may have already been factored into its share price.
  • A company that is steadily increasing its earnings should be able to pay higher dividends, and its share price will be more likely to rise as investors seek both the dividend stream and capital growth.
  • And a company's share price will usually rise if investors collectively believe it has the potential to increase its earnings.

An example

Think of a share for now like a term deposit; they have more in common than you may think. In both cases, you invest your money and can receive regular payments in return. Payments on a term deposit are called interest; payments on shares are called dividends.

Dividends are the principal way a company can reward you for investing in it. If it does not pay dividends, you won't receive anything without selling your shares.

Say you invest $1000 in a term deposit that pays 5 per cent interest annually. You will receive interest payments of $50 each year for the life of the deposit. If you buy shares worth $1000 that pay a dividend yield of 5 per cent, you will receive $50 in dividends for each year you hold them. (Assuming the company pays the same dividend each year.)

It sounds exactly the same, but there is an important difference. The interest payment on the term deposit is fixed, while the dividend payment on the shares can go up or down.

That $1000 term deposit will pay 5 per cent interest, for every year you hold it, unless there's a catastrophe. The income on shares, however, offers no such security - and no such limitations. Shares carry more risk because there is less certainty about whether or not that 5 per cent payment will arrive year after year. It may be much higher or it may disappear altogether.

Investors are generally loss-averse, which means most feel the pain of a $100 loss a lot more - perhaps two or three times more, research suggests - than the pleasure of a $100 gain. Not surprisingly, investors demand a greater return from shares to compensate for the uncertainty and greater risk of loss. But where could this extra return come from?

Well, the increased risk of shares actually holds down their price relative to fixed-interest investments. This leaves more room for price rises in the future, which can mean higher returns from shares.

Historical premium

This historical premium that shares have offered over the "risk-free rate"- essentially the rate of interest the government pays to borrow money from the public - is called the equity risk premium. It is simply the premium for taking the extra risk associated with shares, which runs at something like 5 or 6 per cent per annum, not in every year, of course, but an average over very long periods of time.

This premium only means the potential for higher returns may exist, not necessarily that it will be money in your pocket. Don't think of the premium as some kind of a bonus; the responsibility still rests with you to extract the premium, and then some!

How dividend payments drive share prices

The equity risk premium may sound like a free lunch, but it isn't. Here is what can happen to your dividend payments.

Continuing our earlier example, your $1000 worth of shares pays you $50 (or 5 per cent) in the first year, exactly the same as the term deposit. But, by year two, the economy has entered a golden period.

The term deposit holder gets the regular $50 payment, but the company decides that profits are rising so fast it can reward shareholders with a higher dividend, which it believes can be sustained into the future.

The company pays you $60 (a dividend yield of 6 per cent) instead of $50 (a 5 per cent yield) in the second year. That is obviously good for your wallet but, at least in theory, you have also gained in a second way.

The ball game has changed for new investors, who now face a new choice. They can either pay $1000 for $50 worth of income each year from the term deposit (still at an interest rate of 5 per cent). Or they can buy the shares from you.

Your shares, however, are now paying $60 on the original $1000 investment, an additional $10, so a new investor should be prepared to pay more than $1000 to receive the same 5 per cent yield available from the term deposit. But how much more?

The trick in working this out is to remember the 5 per cent yield holds steady. So the question to ask is: $60 is 5 per cent of what? The answer is $1200. The new investor should now be prepared to pay you $1200 to earn $60 of income each year. Your shares pay more, so they're worth more.

You will have made a $200 capital gain on your original $1000 investment (the share price will have risen) although, of course, you still have to sell the shares at that new price to realise your capital gain.

What if the economy dives?

That is the good news. But there is always the possibility that, instead of heading into a boom in year two, the economy takes a steep dive into recession.

Instead of the company raising the dividend it pays you, it may be forced to cut it to, say, $40. This makes the term deposit, or any other fixed-interest security, a relatively attractive proposition.

The price of your shares will have to adjust downward to attract new investors, so you may incur a capital loss.

After the recession strikes in year two and directors cut the dividend, investors have the choice of paying $1000 for $40 in dividends from your shares (a 4 per cent yield), or $1000 for $50 in interest from the term deposit (a 5 per cent yield). Naturally, they will be inclined to choose the term deposit. For the shares to become equally attractive, they will have to offer at least the same yield as the term deposit (5 per cent).

Just as in the previous example, the 5 per cent yield holds steady and the key question becomes: $40 is 5 per cent of what? The answer is $800 ($40 divided by 0.05 = $800).

Shares that cost $800 and pay $40 in dividends are just as attractive as term deposits that cost $1000 and pay $50 in interest because the yields are the same, at least in theory. Therefore, the capital loss is $1000 minus $800 = $200.

In reality, of course, investors will tend to demand a higher return from shares over time to compensate for the extra risk, but the basic relationship between shares and fixed-interest investments illustrated with this example is an important one.

As bond yields rise, shares become relatively less attractive because they suddenly offer lower yields relative to bonds.

The interest rate effect

What happens if interest rates change? If the interest rate on the $1000 term deposit increases from 5 per cent to 6 per cent (paying $60), while the dividend yield on the $1000 worth of shares stays at 5 per cent (paying $50), it simply doesn't stack up to pay $1000 for the shares.

So the share price would come down to the point where the yield on the shares also equalled 6 per cent. And that new price would be?

Again, the new investor is faced with a choice between spending $1000 on bonds for a return of $60 (6 per cent), or $1000 on shares for a return of $50 (5 per cent).

To be attracted to buying shares, the investor will require at least a 6 per cent yield from those shares. To achieve this without a rise in dividend, the price of those shares will have to come down.

So the key question is: $50 is 6 per cent of what? The answer is $50 divided by 0.06 = $833.33. The share price will adjust downward to approximately $833.33, with a capital loss for the shareholder of $166.67.

Needless to say, the pieces do not always fit together nearly as neatly in the real world. Markets are dynamic, not static, and it is entirely possible that other investors - "the market" - may have forecast a rise or fall in earnings (and subsequently, dividends) long before it actually arrived.

About the author

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