Investors earn returns on equity investment in two ways: price appreciation and dividends. A dividend is a cash payment paid to the investors by the company, and a dividend yield of a stock is the ratio of dividend income received and the price per share. For instance, consider a company paying a dividend of AUD 0.4 per share per annum against the share price of AUD 10 per share. The dividend yield, in this case, will be 4% p.a. (0.4/10).
Dividends are part of shareholders’ returns and a source of income for the investors. Though there is no specific set of rules to pay dividends, blue-chip firms with steady profit growth are more likely to pay the same, while startups in a growth phase are unlikely to do so. The reason is startups need to fund their high growth, and reinvesting all their profit (rather than paying dividends) serves the purpose.
Additionally, in the early stages of a country’s development, investors prefer to get returns periodically (through dividends) rather than waiting for too long. As the country matures, investors develop trust in the corporate sector’s ability to invest wisely for future growth and let the company reinvest the profits by reducing dividends. In this sense, Australia is still an early-stage emerging market compared to the US. Consequently, the dividend yields are higher in Australia.
What is a good dividend yield?
The dividend yield makes it possible to estimate the return on investment of the shares of a company. Assuming that the amount of the dividend paid is not changed, the dividend yield will increase if the share price falls, and conversely will decrease if the price rises.
Consider a company A whose shares are valued at $20 per unit and pay a dividend of $1 per year. A second company B also offers shares valued at $40 per unit and also paying an annual dividend of $1.
In this situation, shares of company A have a dividend yield of 1/20 = 5%, while shares of company B have a dividend yield of 1/40 = 2.5%. All other things being equal, an investor will surely prefer to invest in shares of company A, since it has a yield twice that of company B.
Although a good dividend yield is attractive from an investor's perspective, it is important to note that it can be detrimental to business growth. Indeed, each dollar paid in dividends to the shareholders of the company is one dollar less invested in the activities and the growth of the company, allowing the current capital of the company to grow. Shareholders can also see significant investment returns if the price of their shares rises sharply while they own them.
How to choose the best dividend yield stocks?
Quality stocks with good dividend yields always form an important part of a balanced portfolio. However, the primary thing that investors must keep in mind is that they should not solely focus on the dividend yield to make their investment decisions. Since the yield is a ratio of dividends to stock price, if the market price of the share falls, the dividend yield can be high. Investing in such stocks without knowing the reason behind the drop in the stock price can be counterproductive.
Therefore, investors must also consider other factors as listed below while choosing high dividend yield stocks in Australia:
- Consistency in dividend payout: The company must have a history of paying dividends consistently
- Strong competitive moat: The company should have a sustainable competitive advantage as such companies are better able to generate free cash flow and raise their dividend over the years
- An eye on the balance sheet: A company with a strong balance sheet is in a better place to continue dividend payout over the long term. The investor should avoid companies that have debt-to-equity ratios higher than 2.00 and interest coverage ratio (EBIT/interest expense) below 3x.
Though the companies with higher dividend yields remain in demand among the investors due to their exceptional returns capabilities, Investors should be wary of chasing high dividend yield stocks due to following reasons:
- As discussed previously, the dividend yield is the ratio of annual dividend per share and its price. The yield could increase on the back of a decrease in share price, which can be due to the company’s distressed financials or any other negative events. In such cases, a decrease in dividend per share is expected to follow.
- Increasing interest rates could make the dividend-paying stocks less attractive. For instance, consider the previous example of a 4% p.a. dividend yield. If the interest rate for risk-free assets increases to 7% p.a. for any reason, the 4% p.a. dividend yield would be less attractive.
- Dividends are never guaranteed and are subject to company-specific and market-related risk, similar to the share price. In times of distress, the management may decide to change the dividend policy.
Another important concept that investors must know is a franked dividend. A franked dividend is a system in Australia that helps forgo double taxation on dividends. Franked dividends can be fully or partially franked. Franked dividends help to create more stable and competitive markets by lowering the tax burden on dividends. Franked dividends eliminate the double taxation by giving investors a tax credit, commonly known as a franking credit, for tax paid by the company on that dividend. Subject to minimum holding period requirements, Aa shareholder can reduce the tax by an amount that is equal to the franking credit.
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The formula for calculating a franking credit for a fully franked dividend paying AUD 1,000 by a company whose corporate tax rate is 30% is: Franking Credit = (Dividend Amount ÷ (1 - Company Tax Rate)) - Dividend Amount Franking Credit = (AUD 1,000 ÷ (1 - 0.30)) – AUD 1,000 = (AUD 1,000 ÷ 0.70) – AUD 1,000 = AUD 428.57
The shareholder would receive a fully franked dividend of AUD 1,000 with a franking credit of AUD 428.57 on their dividend statement. If the dividend was not franked, the shareholder is responsible for taxes on the entire amount of AUD 1428.57 (AUD 1,000 + AUD 428.57). When the dividend is fully franked and a franking credit applies, the person still declares AUD 1428.57 as taxable income, but taxes only apply to the AUD 1,000.
Now, as we know what to look for in a dividend-paying stock, let’s see how and where to invest. Usually, there are two main ways to invest in dividend stocks: through mutual funds (index funds or exchange-traded funds) or by purchasing individual stocks. While mutual funds provide access to a diversified portfolio of stocks through a single transaction, it has additional expenses related to fund management. Furthermore, an individual can create a custom portfolio of stocks paying higher dividend income resulting in returns higher than the funds. Consequently, many investors prefer to invest directly in dividend-paying stocks.
Below is a list of 5 fundamentally sound stocks with an economic moat that can help investors to earn good dividend yield:
1. Pendal Group (ASX: PDL)
Pendal Group Limited is an investment management firm that provides services to individuals and institutional clients. The firm launches and manages equity, fixed income, multi-asset, and balanced mutual funds. The company has an annual dividend yield of ~7.9% (industry average: 3.6%) with the current market price of AUD 5.22 per share. The dividend yield is expected to increase to 8.4% p.a. in the next few years.
2. Rural Funds Group (ASX: RFF)
Rural Funds Group is an agricultural Real Estate Investment Trust (REIT) that owns agricultural real estate across Australia and leases them to counterparties. RFF generates its revenues through lease payments and appreciation of the market value of its assets over time. The company has a dividend yield of 3.8% p.a. with the current market price of AUD 3.05. The dividend yield is expected to increase to 4.1% p.a. in the next few years.
3. AGL Energy (ASX: AGL)
AGL Energy Limited supplies energy and other services to residential, small, and large businesses, and wholesale customers in Australia through three segments: Customer Markets, Integrated Energy, and Investments. The company engages in generating electricity, gas storage activities, and the retail sale of electricity, gas, solar, and energy products and services. The company operates an electricity generation portfolio of 11,208 megawatts and serves 4.2 million customer accounts. The company has an annual dividend yield of 5.8% (industry average: 3.3%), with a share price of AUD 8.64 per share.
4. Perpetual (ASX: PPT)
Perpetual Limited is an investment management firm that offers a range of financial products and services in Australia. The company provides funds management, portfolio management, financial planning, trustee, responsible entity and compliance services, executor services, investment administration and custody services, and mortgage processing services. The company has an annual dividend yield of 7.0% (industry average: 3.6%), against a share price of AUD 31.93 per share.
5. Macquarie Group Limited (ASX: MQG)
Macquarie Group Limited provides diversified financial services in Australia, the Americas, Europe, the Middle East, Africa, and the Asia Pacific. The company operates through four segments: Macquarie Asset Management (MAM), Banking and Financial Services (BFS), Commodities and Global Markets (CGM), and Macquarie Capital. The company has an annual dividend yield of 3.0% on the share price of AUD 203.68 per share. The dividend yield is expected to increase to 3.3% p.a. in the next few years.
Note, this information is based on existing tax law and practice in Australia. It is not, and not intended to be, tax advice. Accordingly, investors should seek professional tax advice in relation to their own position.
The list above would help investors generate a regular dividend income through quality stocks and forms a good part of a balanced portfolio. However, to live solely off dividends, the portfolio size should be significantly large. How large should a portfolio be? Considering AUD 72,000 annual living expenses & a dividend yield of 4% p.a., one would need a portfolio of AUD 1.8 million.
Additionally, the investor should remain cautious of slow-growing matured businesses in the portfolio. Depending on such companies can be a problem as the mature business might get disturbed, or growth might slow down further. Instead, the investor should focus on sustainability of the business and capability to grow their dividends.
There is another option in the form of a passive index. There are various dividend-focused passive funds in Australia, such as AMP Capital Equity Income Generator Fund and T. Rowe Price Australian Equity Fund. Living off dividends always has an inflation challenge if the dividend growth is lower than the inflation. So, it is important to look for and invest in funds that can grow the dividend in line with or above the inflation rate
So, is it a good idea to live off dividends? Yes, one can live with a large portfolio. Additionally, the investor can balance the portfolio with growth stocks and debt instruments in addition to the high dividend yield stocks. These kinds of portfolios can generate regular income and high return potential.
At Veye, we cover top dividend stock companies having the potential to deliver substantial returns. If you are keen to invest in stocks that are anticipated to grow at rate significantly above the average growth of the market, then subscribe with us.
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