When it comes to generating an income stream from your investment dollar, most people tend not to think of shares as an attractive option, and this is a great pity. After all, shares can provide you with a regular and reliable income stream that not only outperforms all other asset classes, but also offers you fantastic tax benefits as well.
Perhaps the main reason why people think shares offer poor income returns is because of the quoted dividend yields, which are generally only around 3.5% on average over the long term in Australia, and even less in the US. Pretty unimpressive, right?
Because of this reason, I would be the last to argue that income investors should choose shares over high yielding savings accounts or term deposits in the short to medium term. But the situation changes dramatically over the longer term.
To understand this we need to take a closer look at how dividend yields are calculated. The formula is:
Dividend yield = Full year dividend / Share price
In the above calculation, we use last year’s dividend and the share price used is the most recent closing price. Given this, the yield that is quoted is meaningful only in the sense that it tells you what yield you would receive if:
The company pays the exact same dividend again in the current year
If your purchase price is the same as the most recent closing price
While the dividend yield figure is a useful guide, the fact that both of these assumptions are often wrong acts to disguise what really happens.
For starters, companies tend to increase their dividends each year as they grow their earnings. Indeed, of all the major Australian blue chip companies, virtually all have increased their dividends significantly over the past 10 years. What may surprise many people is that even during the current market downturn, most of the blue chip stocks have maintained or even increased their dividends!
The main reason that dividend yields appear low is because of the continued rise in share prices. We know that dividends tend to increase each year, but because share prices also rise the net result is a dividend yield that stays rather low. But who in their right mind would see that as a bad thing? Would you prefer a high yielding asset that offers very poor capital appreciation?
To accurately judge the yield you are generating from your share investments, you should really divide the full year dividend by your purchase price. Take for example a company that is worth $1 and last year paid a 5c dividend. The quoted yield will be 5%. But if you purchased the shares back when they were 50c, the yield you receive would be double this, at 10%.
Let me finish by making one final important point. In all the calculations we have only considered pre-tax returns. In Australia, because of the dividend imputation system we receive substantial tax benefits in relation to both capital gains and dividend income. I’ll save the detail for another day, but the bottom line is that you only pay a small amount of tax on the dividend income you receive, which means that on an after tax basis your returns are even more spectacular!
So don’t be fooled by the dividend delusion! Quoted yields can be deceptive, and the truth is that over time you will benefit from a consistent, growing and tax effective income stream that will outperform all other alternatives.
Make the markets work for you