The over–looked return – Better Investors

Nov. 10, 2010 - PRLog -- For many investors, the share market is synonymous with capital growth. But capital growth is only one aspect of the stock market story. As an investor in a managed fund, it’s likely you have exposure to shares and are entitled to a slice of a company’s profits. This stake — in the form of dividends or distributions in the case of a managed fund, can provide the lion’s share of equity-based returns in cooler markets, as well as being a valuable source of tax friendly income. In fact, dividends are a considerably more reliable return than capital growth.

The trouble is, amid headlines of share market falls — or conversely, unprecedented gains in stock prices, dividends tend to be overlooked.

It should be noted that dividends are not set in stone. The decision to pay dividends is made by a company’s Board of Directors, and in leaner years, the Board may elect to pay a lower dividend.

Dividend yield — more than meets the eye

Dividends are announced in terms of cents per share. The dividend yield, which allows dividends to be compared with returns on other investments, is determined by dividing the cash dividend by the market value of the share.

For instance, if a dividend of $1.00 is paid on a share with a market value of $20, the dividend yield will be 5%. So even though a dividend may remain consistent in terms of cents per share, when share values fall the dividend yield will rise. Conversely rising share values will reduce the dividend yield.

With this in mind, let’s take a look at how dividends have performed in recent years. Since July 2008, the dividend yield on Australian shares (as measured by the S&P/ASX 200 Index, the institutional benchmark for the Australian market) has ranged from 3.66% in March 2010 to 7.03% in December 2008. The highest yields occurred when share market values fell, and receded as the share market recovered.

At present, dividend yields are in the order of 4.30%. However, this figure doesn’t tell the full story. Thanks to our system of dividend imputation Australian shares give investors plenty of ‘bang for their buck’. Imputation is all about giving shareholders credit for company tax to prevent the same income stream being taxed twice.

When dividends are paid out of profits on which tax has been paid (at the rate of 30%), shareholders receive ‘franking’ credits that recognise the portion of company tax already paid. These credits, which apply whether an investor owns shares directly or through a managed fund, are included in the shareholder’s annual tax return as income and as tax already paid. This can mean paying no tax at all or even receiving a tax refund in recognition of company tax paid on dividends.

For instance, a shareholder on a 30% marginal tax rate (which applies on incomes from $37,001–$80,000 for the 2010/2011 financial year), who receives dividends from a company that has paid company tax at the full rate of 30%, does not have to pay any extra tax. Shareholders on lower marginal tax rates — including superannuation funds and many retirees, can use any excess franking credits to reduce the tax payable on other income and even receive a tax refund.

To make yields from shares paying fully franked dividends comparable on an ‘after tax’ basis with returns from other assets, or even shares paying unfranked dividends, it’s necessary to multiply the yield by 100/70. This reflects the 30% company tax rate, and the process is referred to as ‘grossing-up’ the face value of a franked dividend.

If we gross up the dividend yield for the S&P/ ASX 200 in August 2010, the return rises from 4.30% to 6.15%. This is on par with the highest paying cash investments — a key difference is that returns on cash are fully taxable. A high income investor for example could lose up to half the return on cash to the tax man.

Reinvest for added value

The consistency and tax-friendly nature of dividends make shares a very appealing investment for investors seeking regular income coupled with long term capital growth. And it’s possible to boost the benefit of dividends even further by reinvesting dividend income.

To see just how powerful this strategy can be, it’s worth looking at the long term returns for the S&P/ASX 200 Accumulation Index, which measures the growth in the value of Australia’s top 200 listed companies (by market capitalisation) assuming that any dividends are reinvested.

Over the five years to 31 August 2010, the S&P/ASX 200 Accumulation index has delivered a return of 23%. But over the last ten years, it has notched up a return of 102.6%. Many companies, and managed funds, offer a dividend or distribution reinvestment plan that allows investors to take full advantage of compounding returns. It’s an easy way to make a good thing even better.

The information in this publication does not take into account your personal objectives, financial situation or needs and so you should consider its appropriateness having regard to these factors before acting on it. The taxation position described is a general statement and should only be used as a guide. It does not constitute tax advice and is based on current tax laws and our interpretation. Your individual situation may differ and you should seek independent professional tax advice.

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Dr Chris Caton, BT’s Chief Economist writes every month. To read the latest edition of Caton’s Corner, visit http://www.bt.com.au.