The power of dividend growth

Many investors think that dividend-paying companies are boring, low-return investment opportunities. Compared with small high-flying companies, their volatility can be very exciting, and dividend-paying stocks are generally more mature and predictable. Although this may be tedious for some people, the combination of consistent dividends and rising stock prices can provide a sufficiently strong profit potential that is exciting.

Key points

  • People want to use dividends to provide investment income from their investment portfolios.
  • Dividend yield and dividend payout ratio are two key indicators that investors can pay attention to.
  • Although the growth rate of dividend payments will be slower than the rate of capital appreciation of a stock, in general, investors can rely on increasing the dividend yield to increase returns over time.
  • The power of compound interest, especially when reinvesting dividends, can indeed be a very profitable strategy.

Dividend yield

Knowing how to measure companies that pay dividends can give us insight into how dividends can improve your returns. A common belief is that high dividend yields indicate that dividends have paid a very high return on stock prices, which is the most important measure; however, a yield that is significantly higher than other stocks in the industry may indicate that it is not a good dividend but A low price (dividend yield = annual dividend per share / price per share). In turn, the painful price may signal a dividend cut, or worse, the dividend cancellation.

An important indicator of dividend ability is not so much a high dividend yield as a high company quality. You can find through its dividend history that dividends should increase over time. If you are a long-term investor, looking for such a company will be very rewarding.

Dividend payout ratio

The dividend payout rate, which is the proportion of the company’s income allocated to the dividend payment, further shows that the source of dividend profitability is combined with the company’s growth. Therefore, if a company’s dividend payout ratio remains the same, say 4%, but the company grows, then 4% will start to represent larger and larger amounts. (For example, 4% of 40 US dollars, or 1.60 US dollars, higher than 4% of 20 US dollars, or 80 cents).

example

Suppose you invest $1,000 in Joe’s Ice Cream Company by purchasing 10 shares, at a price of $100 per share. This is a well-managed company with a P/E ratio of 10 and a payout ratio of 10%, which is equivalent to a dividend of $1 per share. This is great, but nothing to write about, because you only received a negligible 1% of the investment as dividends.

However, because Joe was such an excellent manager, the company expanded steadily. A few years later, the stock price was around $200. However, the payout ratio has remained at 10%, as has the price-to-earnings ratio (10); therefore, you now receive 10% of the $20 earnings, or $2 per share. As earnings increase, dividend payments will increase, even if the payout ratio remains the same. Since you paid $100 per share, your effective dividend yield is now 2%, which is higher than the original 1%.

Now, fast forward ten years: As more and more North Americans are attracted by the hot, sunny climate, Joe’s ice cream company has achieved great success. The stock price continues to appreciate and is now at $150 after dividing 2 into 1 and 3 times.

This means that your initial $1,000 investment in 10 shares has increased to 80 shares (20 shares, then 40 shares, and now 80 shares), with a total value of $12,000. If the payout ratio remains the same and we continue to assume a P/E ratio of 10, you will now receive 10% of the return ($1,200) or $120, which is 12% of the initial investment. Therefore, even if Joe’s dividend payout ratio has not changed because his company has grown, dividends alone provide excellent returns (they greatly increase your total return and capital appreciation).

special attention items

For decades, many investors have used this dividend-focused strategy to buy well-known stocks such as Coca-Cola (KO), Johnson & Johnson (JNJ), Kellogg’s (K) and General Electric (GE). In the example above, we showed how profitable static dividend payments can be; imagine a company’s profitability grows to the point where it increases its expenditures.

In 1972, Johnson & Johnson paid an annual dividend of $0.009315 per share. In 2020, it paid a dividend of $3.98 per share. During these 48 years, Johnson & Johnson’s annual dividend has grown at an annual growth rate of 13.5%. It was able to do this in part because over time, as the company’s series of consumer products became more and more stable, these products sold well regardless of economic background, thereby increasing the payout ratio.

For example, in 1993, Johnson & Johnson paid approximately 35% of its net income as dividends. In 2020, it paid more than 62% of its net income as dividends.

Bottom line

Dividends may not be the most popular investment strategy. But in the long run, using tried-and-tested investment strategies for these “boring” companies will have no boring returns.

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