The Power of Dividends
March 1, 2019
One of the most common mistakes that investors make when analyzing the return of a stock is that they look at the how the share price has moved historically, but they omit the return of the dividend. While they may see what the current yield and payout amount is, they often don’t consider it as a part of the total return.
The simplest solution is to take the expected capital appreciation - how much the price of the stock will rise - and add the dividend on top of that. While that gives a decent picture, it ignores the power of compounding.
The Gift that Keeps Giving
If an investor is simply taking the dividend payment as cash it’s accurate to calculate the total return as the sum of the price change and the dividend. However, unless the dividends are being used as income spent immediately, this is a mistake.
If there’s no need to spend the cash payment immediately, investors should be automatically reinvesting dividends. By doing this, the dividend payment is automatically used to buy additional shares of the stock.
Investors can always use dividend payouts to purchase additional shares [without the automated reinvestment] - the problem with that is that most people will forget to do so, until possibly some later date. Most brokers have the option to reinvest either through a financial adviser or online (if the account is self directed).
When the dividends are reinvested it creates a compounding effect. Imagine that you have shares in Costco and you automatically reinvest the dividend. When the dividend payment occurs, you’ll receive additional shares of Costco (in lieu of the cash) which will, in turn, also pay dividends in the future.
With automatic reinvestment the shares purchased can be a fractional amount, and no commission is charged for the stock purchase. The only risk is that the share price of the company falls in the future, however if that’s viewed as a likely scenario, the investor should probably not be in the stock anymore anyhow.
Even without taking into consideration capital appreciation, we can get an idea of how much more could be earned by ensuring the dividends are put into work by using the formula for compounding interest (this is just to illustrate compounding - it doesn’t account for price changes up, or down):
Amount earned from dividend = [P (1 + i)n] – P
P = Principal (total value of stock)
i = interest (dividend yield in this case)
n = number of periods
Using Microsoft in an example where we invest $10,000 and hold it for three years (automatically reinvesting dividends):
P = $10,000
i - 1.64% (dividend yield)
n - 3 times - once per year (this is to simplify the example - to be more precise, it would be 4 payments per year, and the interest rate would be divided by 4)
[10,000(1+0.167)3] - 10000 = $500.11
In this breakdown by year, you can see the compounding effect in years 2 and 3 where the dividend amount increases
If you want to see a total return chart that includes not only changes in the stock price, but also the dividend (compounded), visit Dividend Channel.
Take a look at the difference reinvested dividends has made to the total return of some of the Dow Components over the past decade:
Many investors find utilities unattractive because they’re rarely associated with growth, therefore the stock prices don’t usually rise as much as other sectors. However, in this video technician Carter Worth shows how the total return of utilities actually run close to or above the S&P (depending on timetable) once dividends are factored in.
One thing that can be tempting to do is to look for stocks that have the highest dividend yields - sometimes that’s a good thing, sometimes that’s not good. When analyzing a stock with a high dividend yield, investors should do a little extra research.
Often a high dividend yield happens because a stock’s price dropped. Sometimes this is because the market as a whole fell - CNBC’s Jim Cramer refers to these as “accidental high yielders”. Other times the stock price may be down because of systemic problems with the company. A high dividend doesn’t mean much if the stock price is going to fall.
Even worse is when a company doesn’t have the money to pay owners, and then they’re forced to cut the dividend. In that case the investors not only lose out on the dividend amount they were expecting, but the shares of the company typically crater afterwards as well.
Just check out what happened to CenturyLink when they announced a decision to cut its dividend in half. Not only did investors dividend amount get cut, but the stock price immediately fell 12% in response.
Aside from reviewing earning estimates, cash flow statements, and cash on hand for companies, investors can look to see the dividend history of businesses. One particular metric that can indicate if a dividend can be relied on is the the payment history of the company. If they have a history of raising their dividend amount, it can lend further confidence to the stability of future payments. Dividend.com has a screener where you can see how many consecutive years that a business has raised its dividend.
Dividends Over Growth?
This is not to say that dividend paying stocks are better than ones that don’t (typically growth stocks). Ideally you own stocks that pay dividends, as well as provide growth - such as Microsoft or Apple. While their growth might not be the same as a Netflix, Square or Etsy, they offer a balance of capital appreciation and income.
This is to say that investors should make sure that they’re looking at total return when comparing a stock that pays dividend versus one that doesn’t. Also, it’s important to make sure that dividend stocks are set-up to automatically reinvest the payments.