I’m sure that I’m not the only person that wanted to learn more about the Australian share market, opened up Google, and got smacked in the face with jargon and technical terms.
But why? Surely the fundamentals of investing can’t be that hard to understand.
The cynic in me says that finance professionals like to make the easy sound complex to keep themselves sounding smart in their suits.
Either way, I decided to spend some time explaining the basics of the sharemarket. From ‘what is a share’ to ‘what does an index measure’ to ‘how do unfranked and franked dividends work?’.
This article goes out to anybody who’s had an embarrassingly stupid share market question but was too afraid to ask.
What is the Australian Share Market?
What is a share?
Let’s start at the very beginning. And I mean very beginning. What is a share?
A share (or stock) represents ownership of a business. When you buy shares, you are effectively buying part of the business.
And if you were to buy a business out of the Trading Post (R.I.P), would your rather buy a good one or a bad one?
Excuse the condescending question. Obviously we’d all want to buy a good business. And the same thinking applies to shares.
Fundamentally, people want to own shares of businesses that are performing well. This means that as a business performs better, it’s share price will increase. For people like us, who already own shares in that business, this means that we can sell the shares for more than we bought them. Cha-ching!
When a businesses is performing well enough to increase their share price, we say that the value of the business is increasing. This is because the value of a business is calculated by multiplying its total number of shares with the price per share.
Let’s use Apple as an example. Recently you may have heard that Apple has become the world’s first trillion dollar company. Here’s the math: Apple has 4.8m shares available and the share price is approximately US$220 (at time of writing), so Apple is valued at US$1.07tn.
What is an index?
You’ve probably heard the nightly news droning on about weird finance indices:
“The ASX200 has up 214 points in the day’s trading, which is the highest increase this month” …blah, blah, blah.
It would be rather impractical for the nightly news to run through every share on the ASX and report on it’s daily movements. So they need some measure that can summarise the movement of the market as a whole. For this they use an index.
An index measures the performance a selection of stocks. For example, the ASX200 measures the performance of the largest 200 companies on the Australian Securities Exchange.
If the companies on the ASX200 perform well, then the index will go up. If the companies on the ASX200 perform poorly, then the index will go down. But if some companies perform well and others perform poorly, then the index might go either way.
It’s important to note that most indices are capitalisation weighted, which means that larger companies have a bigger contribution to the index than smaller companies. In the case of the ASX200, if Westpac’s share price increased 2% and Flight Centre’s share price decreased 5%, then the index might still go up because Westpac is a bigger company.
There are plenty of indices available in Australia. Some are based on company size (e.g. the ASX100), industry (e.g. the ASX200 Healthcare Index) or trading strategies (e.g. the ASX200 Growth Index). A list of Australian share market indices can be found on the ASX website.
How do I read a stock market index chart?
We know that the ASX200 is a measure of the 200 largest companies on the Australian Securities Exchange. The All Ordinaries covers the 500 largest companies. Simple as that.
The most common measure of the ASX200 is denoted by the share market ticker XJO. The chart below shows the growth of XJO over the last 10 years. In that time, the index went from about 4,000 to 6,000. This is equivalent of about 4.4% growth per year.
But what does it mean when we say that an index grew?
For most indices, including XJO, an increase in the index indicates that prices for the shares have gone up overall. This is known as capital return.
If we bought our shares when the index was low and then the index goes up, it means that we could sell those shares for a profit.
You might have noticed that the 4.4% yearly growth of the ASX isn’t much higher than a high interest savings account (2.5% or so). And this makes it look like investing in the share market is stupid — we’d be taking on a lot of risk but getting only a little reward.
But that’s not the whole story…
So what are dividends?
Companies are all trying to make a profit. And there is two ways that profit can benefit shareholders:
- Profit can result in capital growth. We just learned about capital growth. As a company makes more money, more people will want to buy their shares and the share price grows higher. Shareholders can then sell their shares to make a profit.
- Profit can be distributed to shareholders as dividends. Remember that shareholders are effectively owners in the business? Some business choose to pay out part of their profit to those shareholders in the form of cash dividends. Literally cash in the bank.
The general view is that companies that dominate their industries and don’t need to invest that money in new technology to remain competitive are most likely to pay dividends. This is because they have leftover cash that they don’t know what to do with.
In fact, it’s generally ‘blue chip’ companies that pay dividends. Such as the Big 4 banks, Telstra, Wesfarmers, and a few others.
Some investors really like the idea of dividend-paying companies. The main reason is that companies tend to continue to pay dividends even when capital growth is low. It is thought that dividends are a more stable form of share market returns.
But how do we determine which companies are high dividend paying?
This is calculated using something called the dividend yield. The dividend yield is a measure of how much dividend we will receive per share. The formula is:
Dividend yield = Annual dividends per share / Share price
Put simply: the higher the dividend yield, the more dividends we will receive from each dollar of our investment.
Dividends come in two forms: franked and unfranked
If this wasn’t difficult enough, I’m going to throw in another curveball: not all dividends are created equal.
In a situation where wereceive a normal dividend (also known as an unfranked dividend), the money arrives in our bank account and is treated as income, so we need to pay tax on it. It’s treated just like the income we receive from our employer.
However, franked dividends are a little different. If a dividend is fully franked, then it means that the company has already paid tax on it. And because it makes no sense to tax that dividend again, we receive the divided plus a ‘franking credit’ which is used to minimise our tax.
To an Australian investor that sits in the 49% marginal tax bracket, an unfranked dividend is taxed at 49c per dollar. However, the fully franked dividend is taxed at 27c per dollar.
In other words, fully franked dividends are almost 1.5x more valuable than unfranked dividends!
It’s a little tricky to understand, so let’s compare the tax bill of an unfranked dividend versus a fully franked dividend:
Let’s assume the company pays a $1000 dividend. If the company has already paid their 30% tax rate on that $1000 dividend, then we receive $700 in dividend and $300 in franking credits.
When tax time comes, we have to pay 49% tax on the total of $1000 (dividend plus franking credits), which comes to $490. But we then get to refund our $300 franking credits, bringing the total tax due to $190.
And the net result is that the unfranked dividend is taxed at 49% ($490 ÷ $1000) and the franked dividend is taxed at 27% ($190 ÷ $700).
How do dividends affect your share returns?
If you recall earlier, I spoke about the stock market indices reflecting capital growth — but not income growth (i.e. not taking into account the benefit of dividends).
So the obvious question becomes: how do we calculate the share market total return that includes both capital growth and income growth?
Fortunately, there are indices that take into account (1) both capital return and dividends and (2) capital return, dividends and the effect of franking credits.
Weirdly though, they just aren’t used that often.
In the chart below I have taken three different ASX200 indices and plotted them with the same starting points.
You can see that different ASX200 indices show different yearly returns. If we just look at capital returns, the ASX200 had a yearly return of 4.4%. If we include dividends then the ASX200 had a yearly return of 9.2%. And if we include the effect of franking, then the ASX200 yearly return was 10.9%.
What does this all mean?
Well, as always, it depends.
We need to remember that looking the ASX200 index with the ticker XJO does not give us an accurate measure of total market returns. It ignores dividends and the effect of franking.
It also raises a question: should we focus on high capital growth stocks or high income (dividend) stocks?
As you’d expect, there’s plenty of informed (and uninformed) debate on this question. And there’s good reasons for both sides of the argument.
We won’t settle the debate here. But I hope this gave you a good baseline understanding to better critique the garbage that some people claim.
As always, if you have any questions, please just drop me an email 🙂
All the best,