FOOL SCHOOL
The Details Of Dividends

August 4, 2004

Following on from our look at what dividends are and when you are entitled to receive them, this article looks at two key ratios used to evaluate them.

Dividend Yield

Dividend yield is a simple ratio used to compare dividend rates against other companies. It is the latest annual dividend divided by the share price and expressed as a percentage. For example, a company with a dividend of 20p and a share price of 400p has a dividend yield of 5% (20p/400p times 100).

The dividend yield is used by many people as a valuation yardstick, that is a measure to determine whether a company's shares offer good value or not. There is more about this concept in this article.

Currently, the average yield for UK shares is around 2% to 2.5%. Shares yielding higher than this (called high yield shares would you believe) are often sought after by those of us looking for some income from our investments. In fact, we have an illustrative 'High Yield Portfolio' included within the Value Investing section of this site.

But...

You need to treat high-yielding shares with caution. Just because a dividend was paid last year does not necessarily mean it will be paid at the same level next year. When a company is in trouble and its share price falls its historical dividend yield could rise to 10% or even higher. In most cases this is a good indicator that the stock market thinks the next dividend will be much lower or no dividend will be paid at all.

Dividend Cover

Wouldn't it be useful to have some method of assessing how secure a company's dividend might be? Another ratio, called the dividend cover, can help you do this. It is calculated by dividing profit after tax by the total amount paid out in dividends. For example, if our company made £50m in post-tax profits last year and paid out £25m in dividends it would have a dividend cover of 2 (£50m/£25m).

A dividend cover of less than 1.5 times is often seen as a warning sign that a cut may be in the offing. A ratio of over 3 times is usually considered as comfortable. But these are only general rules. Another thing to look at is a company's net cash position. A company with plenty of cash reserves is much more likely to carry on paying dividends, for example if it believes that its profits are only dipping temporarily.

The Taxation Of Dividends

All dividend payments declared by companies are effectively net of basic rate income tax. This means that, unless you are a higher rate taxpayer, you do not have to pay any further tax on dividends you receive.

If you have your investments within an ISA or PEP then you pay no tax on your dividends, even if you are a higher-rate taxpayer. In fact, up until April 2004 you will even receive a small tax rebate. There's more on the taxation on dividends in our Taxes Centre and more about in, you've guessed it, our ISA centre.