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Sunny for shares

In my next two articles, I intend to look at the future prospects for equities. My aim is to arrive at a justifiable projection of likely medium and long-term rates of return.

The first commonly used indicator of share performance is the dividend yield. Take the example of a stockmarket-listed company, ABC plc, which has a current share price of 2 and pays a dividend of 10p a year. This represents a dividend yield of 5 per cent.

It is perhaps tempting to compare these yields with the returns on cash deposits and fixed-interest securities. I would suggest that a more pertinent figure is the earnings per share.

ABC plc has made profits of 20m in the last reporting year. With 40 million issued shares, this represents an earnings per share of 50p (the annual profit divided by the number of shares in issue).

What happens to the missing profit of 40p per share, that is, the difference between the 50p profit and the 10p payment to shareholders? Clearly, this profit – often termed undistributed profit – has been retained within the company, usually to fund further expansion.

Now let us move on to the dividend cover ratio. ABC plc’s profit of 50p per share with a dividend of 10p per share represents a dividend cover ratio of five.

At this stage, it is perhaps useful to contrast ABC plc with XYZ plc. XYZ also paid a dividend of 10p last year but only had earnings of 5p per share, giving a dividend cover ratio of only 0.5. Such dividend payments are clearly unsustainable unless profits increase in the coming years.

This leads us back to the earnings per share ratio. Put in simple terms, the eps ratio is the annual profit divided by the number of shares in issue. Alternatively, the eps can be expressed as the dividend yield multiplied by the dividend cover ratio.

Which indicator is most important? On the one hand, the dividend yield is the most obvious indicator as it might seem to give the best comparison with yields from other asset classes. However, if a certain level of dividend seems unlikely to be sustained in future years, past performance might prove to be far from indicative of future returns.

Moving on to look at the market as a whole rather than individual shares, the FTSE Actuaries share indices are crucial when working towards projections of future performance.

Taking the FTSE 100 index first, at a current level of 5,500, the average dividend yield is 3.15 per cent. This compares reasonably well with a typical deposit rate of interest.

But the same index has a dividend cover of 2.3, indicating an earnings per share of 7.245 per cent (the dividend payment multiplied by the dividend cover). I would suggest that this is a more important indicator of long-term returns from equities but it is by no means the end of the matter as these indicators only show past performance.

Each week, the Financial Times summarises the dividend payments and profitability of all listed companies reporting in the previous week. I find it useful to spend a couple of minutes working out the continuing trends. For many years now, I have noted a consistent increase in profitability and dividend payments – not for every company, of course, but for reporting companies in total. Could it be suggested that the following statistics are relevant for equity investors?

  • Dividend yield 3.15 per cent
  • Earnings per share yield 7.245 per cent, leading to
  • Expected future return from equities 7.245 per cent (and increasing).
  • This compares very favourably with cash and represents a significant differential with the rate of price inflation.

    But what about shares outside the FTSE 100? The FTSE 250 index, representing medium-sized companies, has a much lower dividend yield of 2.35 per cent with a lower dividend cover ratio of 2.15, indicating a total return of just under 5 per cent.

    The difference between the indicators for big and medium-sized companies is not unusual and represents the expected lower growth potential of more established companies.

    This assertion is even more pronounced when looking at the FTSE Smaller Companies index, which has a dividend yield of 2.2 per cent and dividend cover ratio of 1.2, representing a total profit return of only 2.6 per cent.

    Where does all this lead us, as regards projected returns from equities in comparison with projected returns from other asset classes?

    First, total returns from commercial property are still over 1 per cent a month, indicating an annual figure well above 12 per cent. Surely, we might assume that this level of return cannot continue? As I have noted in previous articles, however, if we watch the Investment Property Databank index on a monthly basis, we will quickly identify a change in this trend and amend client portfolios accordingly.

    Government bond rates are running at around 4.3 per cent over short, medium and longer terms while high- grade corporate bonds offer around 0.5 per cent premium. These rates are not much different from deposit rates, which is a little disconcerting for those seeking to add value to portfolios.

    On to equities. Funds based on the FTSE 100 should expect to return at least 7 per cent a year while profits continue at their current level. Noting the profit trends I have already discussed in this article, it would seem more than reasonable to suggest that this projection could be very conservative.

    Even if corporate profits increase by only the rate of inflation, current returns of around 7 per cent can be expected to grow by at least 2 per cent, noting the redemption yield of index-linked Government bonds.

    In summary, the evidence points to a positive return (over the rate of inflation) of around 2 per cent from cash. A little bit more might be expected from corporate bonds although not from gilts. Property might be anticipated to provide at least 7 per cent, with a similar projection for equities.

    In my next article, I will bring together all these issues with a confirmed reasoning of the justification for these projections. Keith Popplewell

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