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Why a high dividend isn't necessarily a good thing

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Avoid the yield trap - a high dividend isn't always a good thing, it could even be a red flag

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, may not bring you the generous rewards you expect.

A company's dividend yield is the dividend total it has paid overthe previous 12 months divided by its share price, expressed as a percentage.

For example, Woolworths has paid 84 cents a share in fully franked dividends over the past 12 months. Using the share price of $27.70 at the time of writing, its dividend yield is 3% (84c divided by $27.70).

high dividends red flag

Our dividend imputation system modifies that figure. Imputation sensibly aims to remove the double taxation of dividends. That process leads to the term "grossed up" dividend yield, the dividend amount, in percentage terms, before personal taxation.

The figure enables individual investors to work out their own net yields. To calculate it, you just need to add any franking credits you received along with your dividends, then divide the new total by the company's share price.

In the case of Woolworths, investors received 36c per share in franking credits over the past year, plus the 84c in dividends. The grossed-up dividend yield is therefore 4.3% (84c plus 36c divided by $27.70).

Notice that the dividend yield is calculated using the dividends a company has paid over the previous 12 months rather than what it will pay over the next 12 months. This leads to one of the issues with investing in a company just for a high dividend yield.

The stockmarket looks forward rather than backwards. This means the price of a stock reflects the consensus expectations of the company's future prospects at a particular time.

Once you're comfortable with this idea, and assuming the market is efficient most of the time, which it is, then it's easy to see how a high dividend yield is potentially a red flag. That is, a high dividend yield - perhaps towards the high single digits or occasionally even in the low double digits - may be too good to be true.

Let's look at some examples.

If you had calculated BHP's dividend yield on February 22, 2016 it would have been 9.8% ($1.686 divided by $17.18), a seemingly juicy figure that might have trapped many unsuspecting investors.

When BHP reported its 2016 interim result the next day, the company promptly ditched its "progressive" dividend policy in favour of one linked to underlying earnings.

Anyone who invested in BHP the day before hoping for a 9.8% dividend yield got a nasty shock.

Woolworths from the same period is another example. Based on its $21.89 closing price on February 25, 2016 the company offered a 6.3% yield, fully franked no less.

Yet the very next day it too cut its dividend, as we had 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.

While the market is efficient most of the time, surprises aren't uncommon.

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

In its 2017 result the next day, Telstra announced it would cut dividends starting with its 2018 interim payout. Its share price fell 11% following the news to close at $3.87 - a 5.7% dividend yield based on its estimated 2018 dividend. Many investors were clearly surprised by the cut.

Perhaps the best example of why it pays to downplay a stock's dividend yield can be seen in South32, spun off from 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 the business, its copious cash flows and dividend policy. Anyone investing solely based on South32's yield - then zero - would have moved on.

After commencing paying dividends in September 2016, South32 paid 12.74c in dividends over the previous 12 months - a 10% dividend yield on our $1.28 purchase price. And the stock recently neared $4 a share (and has joined the sell list as a result).

It's unusual to find a mispriced stock that offers exceptional capital growth and a handsome dividend, but it happens.

In investing - as in life - there are no shortcuts. 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. Frequently it will turn out to be a mirage or, worse still, a red flag, rather than an open invitation to invest.

Disclosure: 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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Josh Cole is communications manager for Planet Ark. After working as a journalist and then in corporate communications Josh decided to go to where the grass was greener in the not-for-profit sector at Planet Ark.
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