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Income essentials

This article appeared in the October 2010 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.

Know the basics of dividend yield and franking credits.

Photo of Owen Richards By Owen Richards, AIA

The importance of company dividends to an individual investor depends on their investment style or where they are in life's journey. A conservative or retired investor may prefer to invest in companies that provide a steady and growing stream of income through dividends, as well as to take advantage of taxation credits.

More aggressive investors tend to concentrate investment in high-growth shares because they believe that the growing share price will provide a higher return than dividends, through capital appreciation. Some high-growth companies that are profitable do not pay a dividend, preferring to re-invest profits to fuel their continuing growth.

The famous Berkshire Hathaway company in the United States, at its astonishing price of around $US125,000 a share, has not paid a dividend since the early 1960s.

Dividends are a share of company profits that are paid to shareholders. They are normally paid twice yearly, in the interim period (October) and the final period, calculated on a per share basis.

Dividends can be a sign of financial strength and a real business making real profits. Mature companies with stable profits tend to pay the highest dividends, often with 100 per cent franking credit - what has been called The Australian Gift by one local market commentator. It is a function of the dividend imputation system introduced in 1987.

Tax credit and refund available

Dividend imputation allows investors who have been paid a dividend to take a personal tax credit (franking credit) because the company has already paid company tax (30 per cent) on the dividend. Investors who receive dividend income are only taxed on a figure that represents the difference between the 30 per cent company tax rate and their own marginal tax rate.

Better still, since 2000, if you do not pay any income tax, you can receive a refund cheque representing the 30 per cent company tax that has been already paid.

A company's ability to frank its dividend will depend on how much company tax it has paid on its profit. The company may declare a fully (100 per cent) franked dividend. If it has paid insufficient Australian tax (perhaps because it pays tax overseas), the company may declare a partially franked dividend. If the company does not make any profit, it will not pay any tax, and any dividends the company declares will be unfranked.

Companies with a history of dividend payment strive to maintain payments at the same, or better, level as previous years to meet market expectations. Any indication that a company's dividend is under pressure (for instance, it is having trouble paying its dividend, may cut its dividend or the dividend may be late) signals a warning to the market and the share price usually suffers.

This relationship between share price and dividend is important and, rather than reference to the dividend paid by individual companies, the term dividend yield is the usual way company dividends are expressed. Yield is calculated by dividing the dividend per share by the current share price, expressed as a percentage.

In this sense, the yield is similar to the price-earnings ratio (PER) in that it allows companies to be compared, by reducing each to a common basis. The yield means that the company can be compared to its competitors, index, sector or to the market. Investors can also look at the "total return" - the yield derived from the shares based on the past year's dividend, plus any share price appreciation over the same period.

The franking credits provide an extra bonus and when included with the yield are referred to as the grossed-up yield. A 100 per cent franking credit (at the 30 per cent company tax rate) provides a grossed-up factor of 1.43. This means a 5 per cent yield with 100 per cent franking has a grossed-up yield of 7.15 per cent, which is clearly preferable to a 7 per cent yield that carries no franking credits.

Endogenous and exogenous factors

However, do not fall into the common trap of regarding dividends, yields and price appreciation as somehow immutable. Dividend payments and price appreciation are two very different sides to the one coin. Dividends come into being within a company and are the concrete result of its business operations and the profit this generates. The term for this is endogenous, which means produced or grown from within (the company). As we know, dividends are paid in cash or its equivalent and represent a tangible and permanent gain.

Capital gains, however, are exogenous and have their basis completely outside the business. They are the product of a totally separate organisation (a share exchange) structured to provide a marketplace where shares in the company can be traded. Unless the gain is realised at some point, either partly or in full, it is in no way either tangible or permanent. Price activity can change regularly and quickly, and unrealised gains are often temporary and fleeting.

Some investors in today's market are looking for a yield on their shares that is at least better than the Reserve Bank cash rate (currently 4.5 per cent). The average yield for Australian shares is around 4 per cent (currently 4.3 per cent), which is almost double the world average at a little over 2 per cent. During the recent bull market years, the dividend yields varied between about 3 per cent to just under 4 per cent. The yields peaked to over 7 per cent during the global financial crisis, indicating how many companies continued to pay dividends although share prices slumped.

It should be evident that if the yield of a company is at, say, 10 per cent, you should look at it closely; particularly if this is significantly more that it has paid previously. The share price has probably fallen for a reason, other than just being out of favour for a time. It may also be appropriate to measure the sustainability of the yield.

This is measured by the dividend cover ratio, which is calculated from the earnings per share divided by the dividend per share. The most common ratio in Australia is 1.7 to 2.0 times, which represents a payout of 50 to 60 per cent of earnings. Consideration of yield in share selection should possibly be guided by the Goldilocks principle: "Not too high, not too low, but just right…"

About the author

Owen Richards has been a trader for some years and is a member of the Australian Investors Association, previous editor of its Equities Bulletin, and a contributor to local and overseas trading magazines. The AIA is an independent, non-profit organisation aimed at helping its members become more successful long-term investors. Its holds regular meetings and seminars, which can be viewed online.

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