Finding hidden sources of income from equities

There is a good source of income from equities that even some savvy investors are missing out on, writes Matt Olsen.

In the current enthusiasm for share market yield and “income” stocks, investors usually focus on a stock’s dividend and franking credits.

However, this ignores a more subtle, hidden source of income from equities that even sophisticated investors often completely overlook. This hidden source of income can ensure that the stock in which you invest effectively gives you a pay rise each year that you own it.  

There are really three key sources of current and future equity income. These three components are all funded by the stock’s earning power, or return on equity (ROE) and the level of franking on the dividend. The ROE, when augmented for franking, can be split into these three key components, namely: 

• dividends on equity 
• franking benefits, and 
• retained earnings on equity. 

It is this third factor, retained earnings on equity – the proportion of net earnings not distributed as dividends – which people often completely overlook.  

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Retained earnings on equity drive both the growth in future dividends and the growth in the intrinsic value of the business.

The sustainable rate at which those retained earnings can be reinvested, assuming that balance sheet gearing remains the same, will determine how the net assets, or book value of the stock, will grow. 

If net assets grow, and earnings on those net assets grow by the firm being able to maintain its ROE, dividends will grow.

Intrinsic value will also grow, and over time this should result in capital gains via share price increases – as long as you haven’t paid too much for the stock initially.

Those capital gains can be partially or fully harvested periodically to supplement income above and beyond franked dividends. 

So it is crucial to consider not only the current dividend yield, but also the likely growth in that dividend yield. Such growth is funded by retained earnings.  

Investors often talk about a stock with reference to its franked dividend yield, but you should also start noting and comparing stocks by their retained earnings yield. The higher that yield, the better the outlook for future dividends and capital gains. 

To calculate the retained earnings on equity, you divide earnings per share less dividends per share by the book value per share. Book value is another way of expressing “net assets” (total assets minus total liabilities).

That will give you the retained earnings on equity percentage, which will approximate the expected growth in dividends and growth in business intrinsic value over time.

However, the actual share price growth will depend on how much you pay for the stock relative to that initial intrinsic value. 

If the purchase price is equal to the intrinsic value of the stock, you are therefore paying fair value. Both the dividends and share price should grow in line with the retained earnings on equity percentage over time. 

If the purchase price is lower than intrinsic value, you are getting the stock for a bargain. The dividends should grow by the retained earnings on equity percentage, but the share price will likely grow a little faster as it catches up to intrinsic value over time.

This will result in a higher internal rate of return on the investment than if you had paid fair value. 

If you pay too much for a stock, the dividends should still grow in line with the retained earnings on equity percentage, but the share price will grow at less than the retained earnings on equity percentage. It may even fall significantly. 

The internal rate of return on such an investment will be lower than when you had paid fair value for a stock. You may even experience significant capital losses, which can completely offset any income benefits received from the stock throughout the holding period. Such is the risk inherent in owning “expensive defensives”. 

The counter argument in favour of holding expensive defensives is that if the retained earnings on equity percentage are large enough, the stock can out-earn the premium paid by the investor in a year or two, by which time intrinsic value may “catch up” to the share price. 

My view, however, is that it is seldom wise to overpay for a stock. It is always wise to seek fair or good value. 

The key driver behind all of these factors is the quality of the underlying business and its relative industry position.

This is why fundamental analysts spend so much time trying to find great businesses and buy them at cheap prices.

The better the business franchise, the higher will be the ROE – and depending on dividend policy – the higher this crucial source of equity income, retained earnings on equity. 

Chart 1 shows how the dividend yield has grown for three stocks over the last nine or so years, based on the purchase price of back in 2004.

It demonstrates that if you buy stocks with high levels of retained earnings on equity, like the Commonwealth Bank and BHP, you get a yield that grows nicely over time. 

Telstra’s dividend, in contrast, has remained the same since 2005, based on its 2004 price, although you could have bought it with a dividend yield of over 10 per cent in 2010 when the share price was as low as $2.62.

The big issue for Telstra in growing its yield is that it has very low retained earnings, therefore there is little scope for the dividend to grow. 

Telstra’s share price has grown in line with dividends. That is, it was $4.54 way back in 2004 and is still only about $5 some nine years later. In contrast, the prices of CBA and BHP shares have doubled and tripled respectively.  

Matt Olsen is the head of manager research and deputy CIO at van Eyk Research.