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The Actuary The magazine of the Institute & Faculty of Actuaries

Investment: What is the dividend yield?

A simple question, you may think - but there are some features of the calculation method for published index yields which present traps for the unwary! This article explains these features with reference to the FTSE Actuaries UK Share Index Series.

The first point concerns the companies and their weightings whose dividends are included in the yield calculation. These are the index constituents at the date of the calculation. The weights also reflect their capital structures at that date. Therefore, if the constituents had changed during the previous year, the dividend payments received by an investor holding an index portfolio would not necessarily be the same as those used to calculate the yield. Similarly, capital changes in any constituent over the previous year could lead to a difference.

If the user wishes to know what income would have been received on an index portfolio, the ex-dividend adjustment or ‘Xd adj’ (shown in the FT) provides an accurate assessment. This shows the cumulative dividend payments per unit of the share price index, measured from the start of the calendar year. For a period of a full calendar year or a part thereof, the difference between the adjustment at the end and start of the period provides the income that would have been received during the period. For a period that straddles a year-end, it is necessary to sum the adjustments for the sub-periods on either side of the year end. The percentage income return, or yield, using this measure is the xd adjustment divided by the price index at the start of the period, if you wish to know what the return was for an investment made then.

Users should remember that the income return calculated in this way makes no allowance for reinvestment of dividends. The total return indices, on the other hand, do allow for dividends being reinvested in the index (by incorporating the xd adjustment on a daily basis).

The next point concerns the dividends included for each company. In most cases, it is the dividends declared in the preceding 12 months. However, should a company announce that future dividend payments will differ (up or down) from what has been paid in the previous 12 months, the calculation will take account of the effect of that announcement. Such announcements are relatively infrequent and their effect on the yield on the All-Share Index is normally insignificant.

However, towards the end of 2008, several banks announced that dividends were going to be suspended as a condition for accepting new capital from the Government. When FTSE International implemented this change (using data as at the close of business on 27 November 2008), the impact on the yield on the All-Share Index was a reduction of 0.74%.

In normal times, therefore, the yield is largely historic, but in the current environment it is a hybrid, using historic dividends for most companies but prospective dividends for others. A year after implementing the change with respect to the bank dividends, it will become largely historic again (unless there are other similar announcements with significant impact).

The yield represents the percentage income return on an investment on the day of calculation, provided companies make no further changes to their annual dividend. In practice, many companies will change the dividend each year and users of the yield should make appropriate allowance for this if they wish to estimate future percentage income returns. For example, in the formula for estimating the long-term return on equities, r = y + g, where r is the return, y is the yield and g the assumed growth in dividends, y should be based on income in the first year after investing (a prospective yield). This means that the published dividend yield should be adjusted to allow for the anticipated one year’s change in dividend.

A purely historic yield is useful because it is factual. Users know what is included and can adjust it as necessary using their own estimates of future dividend growth. However, it can be misleading unless the user realises that it applies to payments already made, rather than to what will be paid in future. In comparing different investment opportunities for example, the yield quoted on cash refers to the future, albeit subject to change should interest rates change, and the yield on bonds is a future yield (although normally the gross redemption yield rather than the running yield).

A prospective equity investor looking at dividend yield is more likely to be interested in future income rather than what was paid in the past. For this application, it is appropriate for the yield to reflect all known information, including company announcements regarding future dividend payments. However, for those wishing to convert the yield to a fully prospective basis, starting with a hybrid yield in which most dividends are historic but some are already prospective makes the conversion more complicated.

There is no ideal method of dividend yield calculation which would suit all users. However, as actuaries, we should be aware of what the dividend yield actually means and make appropriate adjustments as necessary.

Ken Forman is the Actuarial Profession’s consultant to FTSE International