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The high yield myth

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With continuing rock-bottom interest rates on savings accounts and term deposits, who wouldn't want a good dividend?

Yet buying a company just because it has a high dividend yield – and not undertaking further research – might not bring you the generous dividends you expect.

 

Dividend yield

But first a few definitions.

A company’s dividend yield is the total dividends it has paid over the previous twelve months divided by its share price.

For example, Woolworths has paid 84 cents per share in fully franked dividends over the past twelve months. Using its share price at $27.00 at the time of writing, Woolworths' dividend yield is 3.1% ($0.84 divided by $27.00).

 

Grossed-up yield

Due to Australia’s dividend imputation system, which sensibly aims to remove the double taxation of dividends, you might also come across a company’s ‘grossed-up’ dividend yield. This is the amount you get before your personal tax, so it enables different investors to work out their own net yields. To calculate this figure, you just need to add any franking credits you received along with your dividends, then again divide the new total by the company’s share price.

So to continue with Woolworths, investors received 36 cents per share in franking credits over the past year, along with the 84 cents in dividends. This means Woolworths’ grossed-up dividend yield is 4.4% ($0.84 plus $0.36, all divided by $27.00).

 

Backward looking

Notice that the dividend yield is calculated using the dividends a company has paid over the previous twelve months rather than what it will pay over the next twelve months. This leads to one of the issues with just investing in a company for its high dividend yield.

The stock market is forward-looking rather than backward looking: the price of a stock reflects the consensus expectations of the company’s future prospects at that particular time.

Once you are comfortable with this – and assuming the market is mostly efficient most of the time – then it should become apparent that a high dividend yield is potentially a red flag rather than a good thing.

That is, a high dividend yield – perhaps towards the high single digits or occasionally even in the low double-digits – may actually be too good to be true.

 

Some examples

Let’s look at some examples.

If you had calculated BHP’s dividend yield on 22 February 2016, it would have been 9.8% ($1.686 divided by $17.18), a seemingly juicy yield.

However, due to low commodity prices, when BHP reported its 2016 interim result the next day, the company promptly ditched its ‘progressive’ dividend policy in favour of one which is linked to underlying earnings. Anyone who invested in BHP the day before hoping for a 9.8% dividend yield would have got a nasty shock.

Another example is Woolworths around the same time. Based on its $21.89 close price on 25 February 2016, the company then seemingly offered a 6.3% yield, fully franked no less. Yet the very next day it too cut its dividend, as we had earlier forecast. In fact the stock rose on the news, reflecting the consensus opinion that the dividend would need to be cut.

In both cases, these companies’ high dividend yields were red flags rather than invitations to load up.

 

Surprise dividend cuts

Yet while the market is mostly efficient most of the time, it too sometimes gets surprised.

An example was Telstra’s recent dividend cut. Based on its $4.33 share price on 16 August 2017, Telstra had a 7.2% fully franked yield: towards the high end for such a large, stable and well known company and, as such, a potential red flag.

Readers probably won't be surprised to learn that, in its 2017 result the next day, Telstra announced it would cut dividends starting with its 2018 interim dividend. Its share price fell 11% following the news, to close at $3.87, giving a 5.7% dividend yield based on its estimated 2018 dividend. So it looks like many investors were actually surprised at the dividend cut.

 

Not dividend paying (yet)

Perhaps the ultimate example of why it pays to downplay a stock’s dividend yield can be seen in South32, spun off by BHP in May 2015.

While the newly listed company adopted a 40% payout ratio, it didn't commence paying dividends until September 2016.

Yet we added South32 to our Equity Income Portfolio in November 2015, nearly a year before we received our first dividend. We did so based on our analysis of its business, its copious cash flows and dividend policy.

But anyone investing solely based on South32's yield – then zero – would have moved on.

And while this is perhaps an extreme example of the negative consequences that can arise from just looking at a company's yield, after commencing dividends in September 2016, South32 paid 12.74 cents in dividends over the last twelve months – a 10.0% dividend yield on our $1.28 purchase price.

In investing – as in life – there are no shortcuts to success. It's always worth investigating a high dividend yield to judge whether it's sustainable. Look at how well it's covered by profits, or better still by free cash flow – and try to assess whether these will be sustainable in future years. Usually it'll turn out to be a mirage, or worse still a red flag, rather than an open invitation to invest.

 

Note: The Intelligent Investor Equity Growth and Equity Income portfolios own shares in BHP, while the Equity Income Portfolio also owns shares in Woolworths.

 

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John Mills is an analyst at Intelligent Investor, owned by InvestSMART (under AFSL 282288). This article contains general investment advice only. It has been prepared without having regarded to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of nabtrade. The article was originally published on 18 January 2018.