Wednesday, April 18, 2012

Dividend Investing Misconceptions

In my four years as a dividend blogger, I have written hundreds of articles on dividend investing and weekly dividend increases. One common question that I receive from readers relates to companies raising distributions for a long period of time, yet their shares have a pretty low yield. It is obvious to long-term readers, which these comments come from visitors that have recently stumbled upon the idea of dividend investing, and therefore have plenty of reading to do before catching up.

In this article I will try to explain this common misconception. The first issue with the statement from the first paragraph is that companies cannot control the dividend yield on their shares. Companies can only influence the dollar amount of dividend payments, which leads to long streaks of consecutive dividend increases, provided that the underlying business model is sound and generates a high level of profits over time. After all, a company can only increase the numerator of the dividend yield equation, whereas the stock market is the one that determines the price of the stock at any given moment.

Investors cannot control the current dividend yield of a stock either. The main edge that dividend investors have over bond investors is the fact that dividend stocks provide the opportunity for increased distributions over time. As a result a stock investor who purchases $1000 worth of a stock yielding 2%-3% today will generate $20-$30 in annual dividend income today. If the stock keeps raising distributions and manages to double them in 10 years, the dividend income that the investor generates will double to $40-$60/year. If the stock price doubles in the process, the current yield would be 2%-3% for new investors. For the original investors however, their yield on cost, would be 4%-6%.

Let’s illustrate with a real-life example. Back in 1988 famous investor Warren Buffett began accumulating shares of Coca-Cola (KO), for his company Berkshire Hathaway (BRK.B). His split-adjusted average cost was $5.23/share. Back then the company paid a quarterly dividend of 3.75 cents/share (adjusted for three 2:1 stock splits in 1990, 1992 and 1996) for an annual distribution of 15 cents/share. The current yield was approximately 2.90%, which is the same as the dividend yield on Coca-Cola (KO) shares today. Investors who purchased Coca Cola at the end of 1988 would have paid $5.58/share, and would have expected 15 cents/share in dividend per year. Fast forward 24 years from that date and these investors would be enjoying a $1.88/share in annual dividend income. The current yield is still 2.69% for new investors. For the shrewd investors who purchased in 1988 however, the current dividend payment equates to a 33.69% yield on cost.

In fact, Coca-Cola stock yielded less than 2% for approximately 14 years after the purchase, yet the company managed to increase dividends every year. Many investors consider yield on cost to be a useless tool. It could be countered, that it is useless for the investors who lack the patience to make a purchase, and then quietly sit back and watch it pay higher dividends over time. The goal of every dividend investor should be to make an investment that pays them higher distributions in the future. Whether the yield on cost is truly a useless metric or not should be left to academicians and market theorists to decide. For ordinary dividend investors, the higher dividend checks received every quarter are sufficient positive reinforcement that their strategies are working correctly.

Full Disclosure: Long KO

Relevant Articles:

Popular Posts