Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 167

Chasing yields is paying dividends

The Australian equity market has performed well over the past few months, though it is once again facing valuations challenges. Irrespective of how the market deals with this challenge, one fact is indisputable: income returns from the market remain attractive relative to interest rates.

Market rebounds amid valuation concerns

The S&P/ASX 200 has staged a feisty comeback (see chart below) and is now over the 5500 barrier. However, this rise has come amid continued weakness in forward earnings. The market’s price-to-forward earnings ratio has again increased to the peak of just over 16 times we saw in early-2015 when the market last ran out of steam. In fact, market prices remain lower now than in early 2015, despite similar PE valuations, due to a decline in forward earnings expectations over this period.

By other measures, however, the market is less overvalued, and potentially cheap. For example, the market’s gross dividend yield (GDY) as of late July 2016 was 6%, which is still significantly above the approximately 2% rate available on 10-year government bond yields and 2.4% on 1-year bank term deposits.

The margin between the GDY and these interest rates is currently around 3.75-4%, which is considerably higher than the (relatively stable) average margin of around 0.75% p.a. between 2003 and 2013. At today’s interest rate levels, retention of this previous average margin would justify a gross dividend yield of only 3.25%, or almost half the current rate.

Does this mean that the market is cheap and should simply surge to reduce the dividend yield? Not necessarily. One complication is the fact that earnings have been relatively weak in recent years, and maintaining a stable dividend yield in the face of rising equity prices has required a rising payout ratio.

Stretched payout ratios

Indeed, the implied payout ratio – or the ratio of the GDY to the forward-earnings yield (inverse of the forward PE ratio) – has risen to about 100% in recent months, compared with a long-run average of around 75-80%. Relative to earnings, the current level of dividends appears unsustainable. Earnings will rise and/or dividends will fall to restore a more normal payout ratio.

Given that dividend yields remain so high relative to interest rates, they are likely to remain attractive even if they do fall to some extent. Let’s assume two scenarios, for example, that earnings hold around current levels for some time, but dividends are eventually cut by 20%, restoring the payout ratio to 80%.

That would imply a decline in the GDY to 4.9%, which is still a substantial 2.4% p.a margin over current 10-year bond yields and 1-year term deposits, while keeping the price-to-forward earnings ratio at its present relatively elevated level of 16.3.

But if interest rates were to hold at current levels, however, there’s even some chance that equity market valuations could be ‘rerated’. This is explored in the table below.

Again, let’s assume that the sustainable margin between the GDY and interest rates referred to above declines to around 1.5% p.a. (which is still twice that averaged between 2003 and 2013), then the gross dividend yield could decline to 4% p.a. Assuming an 80% payout ratio, that in turn would imply a sustainable price-to-forward earnings ratio of 20x!

If we allow for a moderate 1.5% rise in interest rates (to 3.5% p.a.), then keeping all else constant the GDY could still fall to 5%, implying a sustainable price-to-forward earnings ratio of 16x – or not far from current levels.

Official interest rates could fall even further in coming months, suggesting the high-yield equity theme is likely to continue. There’s even a chance the equity market could be rerated higher if interest rates remain below historic average levels.

 

David Bassanese is Chief Economist at BetaShares, whose range of Exchange Traded Funds include high-yield Australian equity investments with ASX codes QFN (aims to track the S&P/ASX200 Financial–x-A-REIT index), HVST (aims to provide investors with a strong income stream from dividends and franking) and YMAX (aims to provide exposure to the S&P/ASX20 index while cushioning returns in weak markets). BetaShares is a sponsor of Cuffelinks. This article is general information and does not consider the circumstances of any individual.

 


 

Leave a Comment:

RELATED ARTICLES

Australia lags global dividend bonanza

Telstra: the dominant player in an improving industry

Doubling down on dividends

banner

Most viewed in recent weeks

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

100 Aussies: seven charts on who earns, pays, and owns

The Labor government is talking up tax reform to lift Australia’s ailing economic growth. Before any changes are made, it’s important to know who pays tax, who owns assets, and how much people have in their super for retirement.

9 winning investment strategies

There are many ways to invest in stocks, but some strategies are more effective than others. Here are nine tried and tested investment approaches - choosing one of these can improve your chances of reaching your financial goals.

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

With markets near record highs, here's what you should do with your portfolio

Markets have weathered geopolitical turmoil, hitting near record highs. Investors face tough decisions on valuations, asset concentration, and strategic portfolio rebalancing for risk control and future returns.

Latest Updates

Investment strategies

Finding income in an income-starved world

With term deposit rates falling, bonds holding up but with risks attached, and stocks yielding comparatively paltry sums, finding decent income is becoming harder. Here’s a guide to the best places to hunt for yield.

Economy

Fearful politicians put finances at risk

A tearful Treasury chief, a backbench rebellion, and crashing bonds. What just happened in the UK and why could Australia’s NDIS be headed for the same brutal fiscal reality?

Shares

Investing at market peaks: The surprising truth

Many investors are hesitant to buy into a market that feels like it’s already climbed too far, too fast. But what does nearly a century of market history suggest about investing at peaks?

Shares

Chinese steel - building a Sydney Harbour Bridge every 10 minutes

China's steel production, equivalent to building one Sydney Harbour Bridge every 10 minutes, has driven Australia's economic growth. With China's slowdown, what does this mean for Australia's economy and investments?

Investment strategies

Will stablecoins change the way we pay for things?

Stablecoins have been hyped as a gamechanger for the payments industry. But while they could find success in certain niches, a broader upheaval of Visa and Mastercard's payments dominance looks unlikely.

Infrastructure

An investing theme you can bet on for the next 30 years

Investors view infrastructure as a defensive asset class rather than one with compelling growth prospects. These five tailwinds for demand over the coming decades suggest that such a stance could be mistaken.

Investment strategies

A letter to my younger self: investing through today's chaos

We are trading through one of history's most confounding market environments. One day, financial headlines warn of doomsday scenarios. The next, they celebrate a new golden age. How can investors keep a clear head?

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.