Trying to understand yield...

Hi all - I'm new to the investment game and trying to get my head around some investment basics – apologies if this is a dumb question…

So, I’m trying to understand the relationship between yield and share price. For simplicities sake let’s forget about franking credits and any other tax considerations. Company X is currently yielding 6%. If I buy 1 share in company X at $100, and assuming forecast yield is the same as actual yield when dividends are paid out, then over the course of 1 financial year I would expect a total dividend of $6 – am I correct so far? BUT, does that mean that when I receive my $6 dividend, the share price will generally reduce by an equal amount – i.e. -$6? So my total actual return (assuming no change in share price other than reduction on dividend payout) would be 0? If this is the case, how does the dividend value ‘accrue’ in the share price over the course of a financial year?

Or do I have this completely wrong?

I know that many things can impact a prospective dividend, but basically what I’m trying to understand is if I purchase a stock yielding say 7% based on the purchase price at the start of the financial year, and assuming no other change to the share price during the year that would result in a capital appreciation or depreciation, would my investment increase by 7%, or would the net effect be 0?

If anyone can point me in the direction of a book or some online material that can help with the basics that would be great!

 

A company will forecast its expected yield. So when you buy the stock, you expect to make a ROI, ie share from company profits.

Yes stock does usually drop by the dividend amount, however the stock capital gain should be greater than the dividend amount over the year.

Think of it this way, everyone knows the stock is paying a dividend in December, so as it comes closer to that time, people pay up for the stock knowing this dividend is coming. The day after dividend, people have to wait another 6 months for the next one to be paid, so the value of the stock is now lower. You can't just buy the stock the day before, collect the dividend, and sell it the next day for the same price. Otherwise why would you own the stock for the whole year!

So using your $100 example, you buy the stock in Jan for $100, in July the stock pays a $3 dividend, and again in December another $3, how ever over the same time, the stock should go up by $6, PLUS its usual capital growth of 6-8%, so capital growth over the year should be 12%, less the 6% dividend yield paid giving you 6% in dividend, and 6% in capital growth.

You will usually find that when a stock does fall, 6-8 weeks later it recovers anyway.

Also note that to get the franking credits, you need to own the stock 45 days before ex-dividend date.

 

Hi crc-error - thanks for that explanation - much appreciated!

However I am still a little confused...

From what you are saying, the share price tends to ramp up in the lead up to a dividend being paid, by an amount similar to the dividend. The share price then reduces post dividend. If that is the case why would I buy a stock in the expectation of the dividend only to see the value of my shares decrease by a similar amount post dividend? Isn't the net effect zero - i.e. may as well keep my cash in the bank? Or do people tend to buy shares for the dividend because it's a tax effective form of income? Appreciate that there are other benefits in owning shares - i.e. hopefully capital appreciation in addition to any dividend, but let's say that capital appreciation is nil (and not negative), do I see an actual return on my investment through yield?

 

You wouldn't buy shares to hold them just for 1 month to collect the dividend. Cause the net effect would be nil.

Dividends are there to reward long term share holders. So if you hold the stock for the whole 12 months, the net result would be the $6 collected from dividends, and at the end of the 12 months the stock will be worth $106 after the dividends are paid, but the stock could have been as high as $112 just before the dividend was paid.

 

Say look at CBA, had you purchased it in 2000, you would have paid $26 per share. 8 years later its worth $40 per share, also twice a year you would have collected dividends so thats 16 dividends over the 8 years, plus collected tax credits in the form of franking and you now have a stock worth $40.

The dividend paid by CBA is 100% tax paid, so you don't pay any more tax, where as interest from the bank, you loose 30% of it at the end of the year in tax.

 

The banks are very cheap at the moment.

Essentially they are paying 9% yield BEFORE tax, PLUS long term capital growth.

Interest in the bank is only paying 6.5% PA with no capital growth.

Where do you think its better to park your money for the long term?

 

Thanks crc_error - it's all slowly becoming clearer : )

Am looking at the likes of the banks and 1 or 2 others that have yields similar to what I can get on a 12 month term deposit (i.e. 8%), and I understand the potential upside from a capital appreciation standpoint, but I guess my thinking is that in the current environment, even though these stocks are 'cheap' in historical terms, there may be little or no capital gain over the next 12 months or so from current prices. However if I'm comfortable that these stocks represent good value for the long term, then I might invest, hopefully safe in the knowledge that the yield will be at least similar to what I can get on deposit, with the potential for upside due to capital appreciation. However if stock prices continue to go south from here, then I'm better of with cash in the bank (in the short to medium term). Who knows!!

 

Best advise I can give is decide on your time frame to invest. Shares really should have a 5 year plus time frame, so during that time, you should not worry about what the capital value does. You will be happy to recieve regular dividends twice a year simular to your term deposit. Then you know that in 5 years time, your shares will be worth more than you paid for them.

If your time frame is only 12-24 months, then the term deposit is the way to go.

You could do a mix of both as well.

Remember at present your buying bargins in the market, so even if the short term is down, you know you have got in at a discount.. Would you rather get into CBA at $40 today when its going down, or get in at $60 1 month before its fall just because it has been trending up prior?