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Dividends as Income

In Part Two we explained why a theoretical share valuation model based on the present value (PV) of a constant future dividend stream in perpetuity (using the latest reported dividend per share capitalized by the current dividend yield as a discount rate) underpins stock exchange listings. We then explained how investors focus on the current yield, a company's annual dividend per share expressed as a percentage of its current share price, to compare its own return over time with that of its peers, or the market and establish whether its shares are over or undervalued. So, if a firm pays a 10 pence dividend in one year and its shares are currently trading at £1.00 (100 pence) the yield is 10 percent. If price rises, the yield falls and vice versa.

If a stock's yield is low compared with its competitors, it could indicate the company is overvalued, which could be a good time to sell and buy back when share price falls to a more equitable level. On the other hand, there may be sound economic reasons why a share is highly valued that could dictate a policy of "hold and buy". Because the yield is a ratio with a numerator and a denominator, falling yields could also indicate that payouts are being cut, suggesting the firm is in difficulties and share price will fall. Investors need to decide whether the cut is a temporary measure, perhaps to finance profitable investment through retention, or is indicative of a fundamental problem.

If one company exhibits a higher yield than its competitors, it could signal that the stock is undervalued, suggesting a "buy" decision. Conversely, it could indicate that the firm is struggling, which has dented share price. Many shares exhibit high yields because their prices have fallen dramatically with little hope of recovery. This is why part of stock market law states that the "higher the yield the higher the risk" and investors seeking regular income assiduously avoid them. Yet high yielding shares can be good value.

Suppose two companies pay a dividend per share of 10 pence that are both valued at £1.00 yielding 10 per cent. The share price of one company then falls to 50 pence, so its yield rises to 20 percent. A speculative investor might buy this "undervalued" share with the higher yield on the chance that its price will rise again. This strategy, termed value investing (as opposed to income investing) is psychologically difficult for extremely risk-averse investors because the price fall may be the consequence of bad news, which is why you are paying half the price for the same dividend per share.

However, you will also recall that another part of stock market law is "buy low and sell high". Investors who bought into the Footsie at its all time peak of 6,930 in September 1999 (prior to the crash) and held on till March 2003 when it plunged to 3,287 suffered 40 per cent losses. But this was the time when value investors pounced, expecting to "beat the market" by benefiting from any upswing, which they did. Naturally, it is a high-risk strategy. So, one way to hedge your bets is to analyse whether a company is sufficiently profitable to continue paying the current level of dividend in the short term.

A convenient measure of dividend risk (published in the Financial Times on Mondays) that we introduced in Chapter Two is the dividend cover. This defines how many times a company can afford to pay its current dividend out of current post-tax earnings. Conventional wisdom dictates twice earnings (cover of two). But again a word of caution: cover can rise if dividends are cut, indicating that profits and price are also about to take a turn for the worse.

Of course, not all shares exhibit low cover or high yields because profits and prices are low in a high-risk sector. Historically, the highest UK dividends tend to be paid on defensive stocks, such as food drink, tobacco and utilities. These consistently outperformed the FT-SE-All Share 20 year average yield of 3.3 percent and also the 4 percent high when the market plunged in March 2003. According to research conducted by motley fool. com who are regularly reported in the financial press like other financial websites, (see this Chapter's Selected References) buying the five shares with the highest dividend yield drawn from the FTSE-30 index every year and repeating the strategy annually, would produce a higher return, compared with a FTSE-30 average. For example, over the twenty year period from the millennium back through the 1980s (despite the 1987 global crash, Euro and Tiger economy crises of the Nineties) you would have made an average annual return of 26.15 percent, compared with the FT-SE 30's 20.38 percent.

Today, investors are enjoying a boom in dividends. Thus, one game plan to make short-term gains in a climate of financial and geo-political instability is to select shares with the highest yield, perhaps covered twice by earnings. If regular income is your motivating factor, share trading must be timed speedily, so as not to miss out on interim dividend payments, particularly if the political situation deteriorates. Most companies distribute dividends every three or six months. But remember, if you buy a share ex-div you are not entitled to the next dividend payment. If you sell ex-div you are entitled to the next dividend, but not any subsequently.

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