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Investment insight: Why dividends?

Dividends are the shareholder’s reward for the risk that he has to bear as co-owner of a company. Pure capital growth (i.e. the increase in the price of the share only) increases the balance sheet of the investor but, unless a dividend is paid as well, he has to liquidate some of his capital to utilise it (with consequent cost and CGT implications).

On the other hand, the investor who receives a tax-free dividend may utilise the cash to further diversify his portfolio or use it for other purposes but the growth investor does not. The investor’s focus, however, should not be purely on dividend yield but rather on the sustainability of dividend growth both historically and in future as this would unlock value.

This point is illustrated in the following example where an investor buys a share with a 5% dividend yield and the company is successful in growing the dividend by 10% per annum. He invests R100 000 and buys 10 000 shares at 1000c per share.

Scenario one: He spends his dividends

Dividends
YEAR 1: R5000
YEAR 2: R5500
YEAR 3: R6050
YEAR 4: R6655
YEAR 5: R7321

Irrespective of movements in the share price, the investor has been rewarded to the amount of R30 526 in the space of five years, i.e. he has already received 30,5% of his initial capital. In Year 5 his yield is a tax-free 7,3% on his initial investment. Assuming his capital grew at 10% per annum in line with the growing dividend the capital value would be R146 000 after five years.

Scenario two: He reinvests his dividends

Number of shares Dividend
YEAR 1: 10 000 R5000
YEAR 2: 10 454 R5750
YEAR 3: 10 929 R6612
YEAR 4: 11 425 R7603
YEAR 5: 11 944 R8744

In Year 5 his dividend yield is higher at 8,7% and the theoretical value of his capital is R175 000.

BUT do such shares exist?

Consider the investment of R100 000 into each of the following stocks with
reinvestment of dividends.

Example one: HIGH dividend yield; LOW dividend growth – PPC

1997
Share price 6000
Dividend 305,33
Dividend Yield 5,1%
Dividend Growth 1,6%
Holdings 1667

1998
Share price 3700
Dividend 325,00
Dividend Yield 8,8%
Dividend Growth 6,6%
Holdings 1804

1999
Share price 5300
Dividend 270,00
Dividend Yield 5,1%
Dividend Growth -16,9%
Holdings 1915

2000
Share price 5500
Dividend 315,00
Dividend Yield 5,7%
Dividend Growth 16,7%
Holdings 2009

2001
Share price 7300
Dividend 340,00
Dividend Yield 4,7%
Dividend Growth 7,9%
Holdings 2096

Value 152 991
Total Gain 53%
Total Dividend 7126
Yield on Investment 7,1%

Example two: LOW dividend yield; GOOD dividend growth – RICHEMONT

1997
Share price 530
Dividend 7,75
Dividend Yield 1,5%
Dividend Growth 36,7%
Holdings 18 868

1998
Share price 831
Dividend 11,37
Dividend Yield 1,4%
Dividend Growth 46,7%
Holdings 19 044

1999
Share price 1522
Dividend 13,44
Dividend Yield 0,9%
Dividend Growth 18,2%
Holdings 19 186

2000
Share price 1960
Dividend 15,25
Dividend Yield 0,8%
Dividend Growth 13,5%
Holdings 19 318

2001
Share price 2180
Dividend 19,93
Dividend Yield 0,9%
Dividend Growth 30,7%
Holdings 19 453

Value 424 074
Total Gain 324%
Total Dividend 3877
Yield on Investment 3,9%

Example three: ERRATIC dividend payer; POOR dividend growth – HL&H

1997
Share price 465
Dividend 0
Dividend Yield 0%
Dividend Growth 0%
Holdings 21 505

1998
Share price 400
Dividend 0
Dividend Yield 0%
Dividend Growth 0%
Holdings 21 505

1999
Share price 635
Dividend 9,00
Dividend Yield 1,4%
Dividend Growth 0%
Holdings 21 505

2000
Share price 600
Dividend 7,20
Dividend Yield 1,2%
Dividend Growth -20%
Holdings 21 828

2001
Share price 735
Dividend 10,00
Dividend Yield 1,4%
Dividend Growth 38,9%
Holdings 22 041

Value 160 004
Total Gain 62%
Total Dividend 2204
Yield on Investment 2,2%

Conclusion: Investors should place significant emphasis on the dividend growth potential of a stock as sustained dividend growth can unlock real value over time. In uncertain times dividends also offer the investor the opportunity to diversify his portfolio at good prices.

Carel Wolhuter is an analyst at Sasfin Frankel Pollak Securities, their Investment Letter is published monthly

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The Big Change is a business strategy blog and newsletter published by Arthur Goldstuck, managing director of World Wide Worx, a leading technology research organisation based in Johannesburg, South Africa.

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