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Yielding Income Without Dividends

Yielding Income Without Dividends

Chasing yield and ignoring growing income is a mistake and in the long run, it will prove costly for its adherents.

Take a business with $10 of equity per share and earning 20 per cent returns on that equity (ROE).  In the first year the earnings will be $2.00 and if the directors acquiesced to shareholder demands and paid all of the earnings out as a dividend, the dividend would also be $2.00 per share. Now, if we assume that the popularity of the shares never changes and they trade at ten times earnings, the shares will be priced at $20 in the first year.  You will note now that the dividend yield is 10%.  It all seems very attractive in the context of today’s miserable returns on cash and term deposits. 

If we then assume that in the second year the company commences with the same equity it had at the end of the first year - $20 – and it earns another 20 per cent return, then the earnings will also be $2.00.  You will note there’s no growth, but as the popularity of Telstra shares has shown, you don’t need growth in earnings or dividends to keep a share supported.

The reason there is no growth in earnings is because we are assuming that the ROE stays constant. It is also a fact that the company pays all it’s earnings out as a dividend and so there is no capital retained to grow the equity base.

All this is rather academic until you get to the return you are going to make.  If we assume that the company’s shares trade at 10 times earnings at the time you buy the shares and also at ten times earnings when you sell, then if the above pattern of returns and dividend payments were to continue year after year, your return will just be 10% per annum.

Now here is where it gets really interesting.  Suppose the company paid no dividends and instead retained all of the profits so that the equity grew each year, and the company continued to earn 20 per cent returns on the increasing equity.

If you bought and sold this company’s shares on a price to earnings ratio of ten times, you would end up with an annual return of 20% and double the return from taking the dividends.

In other words by demanding a dividend equivalent to 100% of the earnings, the opportunity cost is as much as double.

The rubber really hits the road with a real example.  In 2005 you could have bought $100 worth of Telstra shares (ASX: TLS) at $4.69 on a 5.97% yield - paying $5.97 on your $100.  Alternatively you could have purchased shares in another, much smaller telco, called M2 telecommunications (ASX: MTU).  Unfortunately the dividend yield wasn’t as attractive as Telstra’s at 3.91% so your income on a one hundred dollar investment was just $3.91.

You’d be forgiven for opting for the higher yielding Telstra shares, but as we demonstrated a moment ago, the returns are higher when a company can retain profits and continue to generate high returns.  And that’s what M2 did.

Your $100 investment in Telstra in 2005 is today worth $132. Importantly the dividends have been steady and you are now earning $6.40 per year in dividends.

Contrast this with MS however. Because M2 has been able to grow its equity through retaining profits (and admittedly other techniques such as capital raisings) and employ the additional capital at high rates of return the growth in the value of the business has been much greater than Telstra’s growth.

A $100 investment in M2 has grown to $3,453 today as the share price surged from 32 cents ten years ago to over $11 today.  More importantly you should recall you didn’t buy M2 shares because you needed the higher income that Telstra was offering in 2005.  That’s a pity because today, the income on the shares that you originally purchased for $100 is $93.75.

In other words going for growing income rather than yield has delivered more income and more wealth.  You really can have it all.

 
Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, blog.rogermontogmery.com. Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of Value.able and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!