Many investors think of dividend-paying companies as boring, low-return investment opportunities. Compared to high-flying small cap companies, whose volatility can be pretty exciting, dividend-paying stocks are usually more mature and predictable. Though this may be dull for some, the combination of a consistent dividend with an increasing stock price can offer an earnings potential powerful enough to get excited about.
High Dividend Yield?
Understanding how to gauge dividend-paying companies can give us some insight into how dividends can pump up your return. A common perception is that a high dividend yield, indicating the dividend pays a fairly high percentage return on the stock price, is the most important measure; however, a yield that is considerably higher than that of other stocks in an industry may indicate not a good dividend but rather a depressed price (dividend yield = annual dividends per share/price per share). The suffering price, in turn, may signal a dividend cut or, worse, the elimination of the dividend.
The important indication of dividend power is not so much a high dividend yield but high company quality, which you can discover through its history of dividends, which should increase over time. If you are a long-term investor, looking for such companies can be very rewarding.
Dividend Payout Ratio
The dividend payout ratio, the proportion of company earnings allocated to paying dividends, further demonstrates that the source of dividend profitability works in combination with company growth. Therefore, if a company keeps a dividend payout ratio constant, say at 4%, but the company grows, that 4% begins to represent a larger and larger amount. (For instance, 4% of $40, which is $1.60, is higher than 4% of $20, which is 80 cents).
Let's demonstrate with an example:
Let's say you invest $1,000 into Joe's Ice Cream company by buying 10 shares, each at $100 per share. It's a well-managed firm that has a P/E ratio of 10, and a payout ratio of 10%, which amounts to a dividend of $1 per share. That's decent, but nothing to write home about since you receive only a measly 1% of your investment as dividend.
However, because Joe is such a great manager, the company expands steadily, and after several years, the stock price is around $200. The payout ratio, however, has remained constant at 10%, and so has the P/E ratio (at 10); therefore, you are now receiving 10% of $20 in earnings, or $2 per share. As earnings increase, so does the dividend payment, even though the payout ratio remains constant. Since you paid $100 per share, your effective dividend yield is now 2%, up from the original 1%.
Now, fast forward a decade: Joe's Ice Cream Company enjoys great success as more and more North Americans gravitate to hot, sunny climates. The stock price keeps appreciating and now sits at $150 after splitting 2 for 1 three times.
This means your initial $1,000 investment in 10 shares has grown to 80 shares (20, then 40, and now 80 shares) worth a total of $12,000. If the payout ratio remains the same and we continue to assume a constant P/E of 10, you now receive 10% of earnings ($1,200) or $120, which is 12% of your initial investment! So, even though Joe's dividend payout ratio did not change, because he has grown his company, the dividends alone rendered an excellent return - they drastically increased the total return you got, along with the capital appreciation.
For decades, many investors have been using this dividend-focused strategy by buying shares in household names such as Coca-Cola (Nasdaq:COKE), Johnson & Johnson (NYSE:JNJ), Kellogg (NYSE:K) and General Electric (NYSE:GE). In the example above, we showed how lucrative a static dividend payout can be; imagine the earning power of a company that grows so much as to increase its payout. In fact, this is what Johnson & Johnson did every year for 38 years between 1966 and 2008. If you had bought the stock in the early 1970s, the dividend yield that you would have earned between then and now on your initial shares would've grown approximately 12% annually. By 2004, your earnings from dividends alone would have given a 48% annual return on your initial shares!
The Bottom Line
Dividends might not be the sexiest investment strategy out there. But over the long run, using time-tested investment strategies with these "boring" companies will achieve returns that are anything but dull.