Don’t Bank on Bank Dividends
Mark Nathan – Financial Services Analyst
Australian life expectancy is amongst the highest in the world. The average male will live for more than 15 years after retirement, while the average female lives for almost 20 years after retirement. Because cash and bonds will unlikely provide an income that maintains their real value (i.e. after taking into account the effect of inflation), many financial advisers recommend shares as an important component of retirement income.
The Australian banks have long been a key part of a post retirement income generating share portfolio. This is not a surprise when you consider the attractive fully franked dividend yield that these companies offer.
Source: Arnhem, Company Accounts, Iress
While ANZ has already cut its dividend, the question is whether the dividend yield offered by the other banks is sustainable. Or, are those retirees relying on this income stream in for a nasty surprise? We think the latter.
The sustainable dividend is a complex interaction between the capital required to support the growth of the bank and the ability of the bank to generate capital organically. The faster a bank grows, the more capital it will require. This is because every time a bank lends money, it is required by the regulator to hold a certain amount of capital. In rough terms, for every additional $100 a bank lends, it will be required to hold an additional $6 to $7 in capital. This additional capital needs to be funded from retaining some of the profits and not paying it away as a dividend. If a bank paid out all of what it earns as dividends (100% payout ratio), it would find itself in a situation where it could not support any growth in its lending book.
Thus, the amount that a bank can afford to pay out is directly related to how quickly it wants to grow. The exact maths will also depend on how efficiently a bank can generate capital organically. This is best measured by its return on equity (ROE). We think the ROE of the industry will decline in light of the regulatory requirement to hold increasing levels of capital. We assume it will settle at 13%, or 1% below where it is today.
We can calculate this relationship between lending growth and the sustainable dividend payout ratio for the industry as follows:
That is to say, if the industry wants to grow the amount it lends by 4%, it can only pay out 80% of its profits as dividends. The calculations done by NAB equates to a less flattering 72% payout for the same inputs.
Both NAB and Westpac are paying out around 80% of their earnings already. This means any resurgence in lending growth is likely to see dividend cuts. Of course, they could try and tweak their internal models for calculating capital requirement but that would only postpone the cut by a year at most. The best chance of maintaining dividends is to grow earnings by cutting costs, as this will allow each to grow earnings without additional capital impost. We contend that this, too, will be insufficient to avert a dividend cut. Given their lower payout ratio, ANZ and CBA are more likely to be able to sustain their current dividend.
Source: Arnhem, Company Accounts (ANZ payout ratio normalised for special items)
The good news is that the two banks most likely to cut their dividends – NAB and Westpac – are both offering higher dividend yields at the current time. This is probably due to the market foreshadowing this potential cut. Thus, we are not forecasting the value of bank shares to reduce significantly if there is a dividend cut. However, anyone relying purely on dividends from bank stocks should consider the impact of a possible dividend cut over the next 12 months.
This article has been prepared by Arnhem Investment Management Pty Limited ABN 17 129 606 775, AFSL 332484. It pays no regard to the specific investment objectives, financial position or particular needs of any specific recipient. You should seek your own professional advice in relation to any financial product referred to. You should also obtain the product disclosure statement relating to any financial product referred to and consider the statement before making any decision about whether to acquire the financial product. This article, including the information contained herein, may only be copied, reproduced, republished, or posted if done so in whole with original disclaimer included. © Arnhem Investment Management, 2016