The Importance of Dividends

Overview

Given the challenging environment for the income seeking investor when interest rates on cash held on deposit remain unappealing, don’t under estimate the importance of dividend income.

The UK is one of the higher yielding markets globally, and whilst the constituents of the major indices may have changed over the years, there are currently a large number of companies with attractive dividend yields and with the scope to grow these pay-outs above the rate of inflation.

The importance of the dividends

The importance of the dividend as a component of an equity investment’s total return is evident if we consider the relative performance of the FTSE 100 index from its closing high in 1999 and the performance of the FTSE 100 Total Return index over that same period:

  • On 30th December 1999 the FTSE 100 peaked at 6930 with a dividend yield of 2.04%. Put another way, if we were to view the FTSE 100 as a portfolio in which each point equates to £1, the value would amount to £6,930 and the 2.04% yield would imply dividend income of £141.37. Dividends have subsequently grown by some 41.9%, with the yield on the index currently 3.70%, implying dividend income of £200.63.
  • The FTSE 100 closed on 6th June 2012 at 5441, some 21.5% lower than the 6930 closing high on 30 December 1999. However, the FTSE 100 Total Return index – which combines both the capital performance and the reinvestment of dividends – at 3713, is up by a little more than 18% over the same period and dividends have subsequently grown by 48.7%.
  • At 5441*, the FTSE 100 yields 3.70% net of standard rate tax (equivalent to 4.61% gross for a basic rate taxpayer) implying dividend income of £200.63 – this is despite a period during the 08/09 recession when a number of large dividend payers, including the banks, cut their dividends as they sought to rebuild their balance sheets and BP cut the dividend following the disaster in the Gulf of Mexico.
  • Whilst these events serve as a reminder that dividends are not guaranteed and can be cut if a company comes under stress, company balance sheets now are generally in a stronger position than they were just before the financial crisis and a number of companies are sitting with excess cash on their balance sheets. These stronger balance sheets combined with growing confidence of management in their company’s trading outlook, is providing a favourable backdrop for further dividend growth.
  • Since 1999 the dividend yield has outperformed CPI inflation but has kept pace with the RPI.

Dividend taxation

Dividend taxation can be a difficult concept to understand, especially since the introduction of the 10% tax credit in 1999 and many people overlook the fact that dividends are expressed net of standard rate tax, whereas savings accounts, for example, express interest rates as gross.

Some interesting points to consider on current FTSE 100 yields*:

  • The FTSE 100 currently yields 3.70% net of standard tax, equivalent to 4.61% gross
  • The top 7 stocks in the FTSE100 index with dividend cover of over twice times yield 5.63% net of standard rate tax, equivalent to 7.0% gross
  • The top 5 stocks in the FTSE100 index with dividend cover of over twice times yield 5.91% net of standard rate tax, equivalent to 7.4% gross
  • The top 7 stocks in the FTSE100 index with dividend cover of over one and a half times yield 5.77% net of standard rate tax, equivalent to 7.2% gross
  • The top 5 stocks in the FTSE100 index with dividend cover of over one and a half times yield 6.02% net of standard rate tax, equivalent to 7.5% gross

Risk

You should be aware that investing in equities is not suitable for everyone and has a higher risk associated with it than deposit accounts as you could lose some or all of your investment.  Past performance of investments is not a guide to future performance. The tax treatment of investments may change with future legislation.