The importance of grossed-up yield

Nicholas Grove: With a lot of emphasis being placed nowadays on the place of solid dividend paying stocks in a good portfolio, investors may be reading a lot about the notion of grossed up yield. Here to help us get a better understanding of the concept, I'm joined by Morningstar's Senior Equities Analyst, James Cooper. James, thanks very much for joining us.

James Cooper: No problem, Nick.

Grove: First of all, James, what is meant by grossed-up yield?

Cooper: Look, the whole purpose of grossing up a dividend is to work out what -- how much profit is being distributed before tax. So, if you look at a company's profit and loss, they make a profit before tax and then pay a certain amount of tax on that profit. The corporate tax rate is 30%, but they may, for a variety of reasons, pay more or less than 30%. But the idea is to take the dividend which is paid out of those profits and work out what that dividend equated to before tax was paid by the Company.

So, if the Company has paid a 30% tax rate, imagine that they earned $100 of profit before tax. They then paid $30 of tax, giving them a profit after tax of $70. Now, if they then distributed that all as a dividend, they would have paid out $70. Imagine you were the sole shareholder, you received that $70. To gross that back up to the pre-tax amount, you multiply it by 100 over 70 right, which is �happens to be about 1.42, and that gets you back to the pre-tax amount.

Then as the shareholder who has received that dividend, when calculating what tax you pay on that dividend, you get a credit, a franking credit for the tax that was paid by the Company. So, the purpose is to ensure that the double taxation doesn't occur. You know, you own a company, it's paid tax, you've effectively paid tax. Why should you then pay a full amount of tax on that dividend when it's distributed to you if it's already taxed?

So, that's what it is. Sometimes, if the Company may have paid less tax than the 30%, you then receive a dividend, which is not termed a 100% franked. It might only be -- let's say it's 50% franked, meaning that only half the tax has been paid on that pre-tax amount. In which case, when you gross up your dividend for the purpose of calculating your tax, you then say 50% of that 0.42, so roughly 0.21 is then used in the calculation. So, it becomes 1.21 times the dividend that you have received. That gives the pre-tax amount. You then calculate the amount of tax as an individual you would pay on that amount of profit and then subtract what the company actually paid and you end up with paying the full amount of tax in the individual�s hands, but not doubly taxed.

Grove: James, why is grossed up yield important?

Cooper: Well, if you look across a range of companies, you�ll -- almost always dividend yields are just given in a -- as a net amount. They don't gross it up. They just tell you, you know, such and such is paying 5%. This one is paying 7%. This one is paying 3%. Now, if you don't gross them up, you actually get a false view of what that yield really is after-tax in the hands of the shareholder. So, the 6% yield, if it's not franked, will not actually be as valuable in most shareholders' hands as a 5% fully franked yield once you've got the benefit of the franking.

Grove: Finally James, just to reiterate, how do you calculate grossed up yield?

Cooper: Yes. Well, you start off saying, with your 100 over 70, which again is -- it's round about 1.42, and you multiply your dividend yield, say it's 5%, you'll multiply that by 1.42, which comes to a little bit over 7 I think it is, and that's your true yield which you then need to apply your personal tax rate to.

Again, if it's not 100%, if it's 70% franked, you then have to take that 0.42 part of that 1.42, so 70% of that 0.42 which gives you roughly 0.3. The equation then is 1.3 times the dividend yield.

Grove: James, thanks very much for joining us.

Cooper: That's a pleasure Nick.