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Education Article – A closer look at dividend yields

Introduction

With interest rates on bank deposits getting lower and lower, investors are looking around for more attractive sources of income. One option that is becoming favourable again is to buy shares in listed companies that are trading on high dividend yields. It therefore seems appropriate at this time to have a closer look at Dividend Yields.

How is the Dividend Yield calculated?

The Dividend Yield for any particular stock is the Dividend per Share (for that stock) divided by the Share Price.

For example, assume the share price of Commonwealth Bank (ASX:CBA) is $58 and CBA pays a full year dividend of $3.34 per share. The Dividend Yield for CBA is 5.76% ($3.34 / $58).

Do I only need to focus on the Dividend Yield when buying stocks?

Although the Dividend Yield is important, the Total Return from investing in shares has two components: the Dividend Yield combined with the Capital Profit or Loss due to the change in the share price of the company.

Are stocks with the highest dividend yield the best to buy?

No, not necessarily. As explained above, the denominator in the Dividend Yield calculation is the current share price of the company. If, for example, the outlook for the company is weak and the market expects the company to reduce its future dividends, the share price will have dropped in value to reflect this negative sentiment and the Dividend Yield would be correspondingly higher. Even though the share price has dropped this does not make investing in this company necessarily sound as a future reduction in dividends would mean the investor will not receive the anticipated dividend yield.

What are the most important considerations when buying a stock for Dividend Yield?

The most important factor to consider when investing in a company for its Dividend Yield is to ascertain if the dividends are sustainable. A greater level of certainty can be attained if the following criteria are met:

  • The company has a long history (more than 10 years) of always paying dividends
  • The company has a record of increasing dividends from one year to the next
  • The payout ratio, that is, the ratio of dividends to earnings, is not higher than 75%
  • The company generates sufficient free cash flow to pay the dividends
  • The company has a strong balance sheet with low levels of debt
  • The company has a sound underlying business with a sustainable competitive advantage.

Are there any tax implications to consider when investing in dividend-paying stocks?

Dividends are often worth more than the cash payment you receive. This is because a company can also distribute franking credits for any company tax it has paid. Franked dividends carry imputation credits, which entitle shareholders to a tax offset or a reduction in the amount of tax to be paid. By including the franking credits, the gross dividend yield on the CBA example is 8.23%*.

* gross dividend yield = dividend yield / [1 – (30% x franking percentage] where franking percentage may vary but for CBA equals 100%

Disclaimer

The information contained herein is of a general nature and does not take into account the reader’s particular needs, circumstances, financial circumstances or preferences. It is a guide only and based on current legislation. We believe the information contained in this update has been obtained from reliable sources but we cannot be responsible for any errors, omission or inaccuracies. You should seek professional advice before acting on the information in this update.

Please contact your Intralink Wealth Management adviser, on (03) 9629 1100, if you require any clarification or further information regarding this update.

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