Dividends are crucial to stock market returns. As they compound over time, the significance of dividends explodes. It is estimated that over the past 100 years or so, nearly one-half of the market returns - as defined by the Dow Jones Industrial Average and S&P 500 Index - are a result of dividends.
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The Obvious Points
Basic math illustrates the power of dividends. You buy a share of stock for $20 and pays an annual dividend of 50 cents, or approximately 2.5%, a year. Typically, most companies that pay dividends strive to maintain an attractive yield, so over time as the company grows, the dividend payouts grow as well. Several years later, the stock trades for $35 and it still yields 2.5%, or approximately 88 cents a year. Based on your $20 dollar purchase price, the yield is actually over 4%. (For more, see Dividend Facts You May Not Know.)
Look no further than the Johnson and Johnson (NYSE:JNJ) to really appreciate the above scenario. In 1990, JNJ paid a total dividend of about 16 cents against an average share price of around $8, representing a yield of approximately 2%. Against the $8 share price of 1990, today's dividend constitutes a near 25% return from dividends alone. Factor in the stock price appreciation and you may wonder why you own so many stocks. (For more, see The Power Of Dividend Growth.)
Not So Obvious
Aside from the power of compounding and growth noted above, dividends also tend to create a culture of discipline. Unlike profits, dividends must be paid each quarter. They are real and tangible. Failure to pay a dividend will likely raise a red flag to investors. Knowing this, management is less likely to go gambling on risky projects just for the sake of it as they realize that oftentimes the company dividend is what attracts an investor base. Of course, a dividend should only be paid when management confidently knows it can't reinvest that money in the business and earn a higher return. This why for years, Microsoft (Nasdaq:MSFT), a cash cow, never paid a dividend as it continued to plow money back in the business and grow it rapidly. But now, Softy generates more than enough cash to meet its needs and so it pays a dividend, albeit a very minimal one at this point. (For more, see Dividend Yield For The Downturn.)
A Great Collection of Businesses
Today's best companies are boasting good yields as a result of stock price declines caused by the market meltdown of the financial crisis. And they represent some of the best businesses in the world. They are generating enough cash to both meet growth needs and pay attractive dividends. Oil giant ConocoPhillips (NYSE:COP) currently sports a nearly 4% yield and the stock trades around 8-times earnings on a forward year basis. Defense giant Lockheed Martin (NYSE:LMT) sports a forward P/E of 9.66 and yield of 5.40%.
Clearly, no investment should ever be made solely on account of a dividend. A 6% yield isn't as helpful if you're paying a premium price for the shares. As always, the first consideration should be buying at a price below intrinsic value. At today's prices, many of the dividend payers are in fact trading at reasonable prices, making this space a worthwhile area for investment ideas. (For more on this topic, see The Importance Of Dividends and Build A Dividend Portfolio That Works For You.)
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