In investing, what really matters is the total return on investment. In the case of stocks, it is usually a combination of dividend yield and capital appreciation. However, are both components equally valuable, and should they be treated the same?
The following analysis will show why the same amount of dividend income or the same amount of percentage dividend yield is substantially more valuable than the same amount or percentage of capital appreciation, all other things being equal. The analysis will also reveal exactly how large the benefits are, and the possible limitations.
Dividend payout and dividend yield
The annual dividend yield shows how much a company pays out each year relative to its share price. The dividend payout is calculated as a simple sum of all dividend cash flows paid out during a given year.
Capital appreciation can be expressed as a percentage change of the current price versus the price a year ago. Or, in absolute terms, the capital appreciation is a simple difference of the current price and the price a year ago.
Where is the difference?
There is one crucial difference between the calculation of dividends and capital appreciation, which makes the direct comparison of absolute values or percentages an apples-to-oranges comparison.
Dividends are usually paid out quarterly for most dividend-paying U.S. stocks. Some stocks and other investment vehicles even pay out a monthly dividend, which further exacerbates the stark difference between dividend yield and capital appreciation.
This multiple number of payouts spread over time is what makes dividends very different from capital appreciation, which is simply a measurement of one value at one time compared with a year-ago status - and the time is at the end of the dividend payout period, when all annual dividends have already been paid.
On the other hand, dividends are paid earlier, throughout the year.
Let's consider quarterly dividends. For our calculations, let's assume that the first quarterly dividend is usually paid out three months after the stock purchase and not immediately, because even if an investor buys the stock right before the ex-dividend date, the stock price virtually always reflects the dividend payout the first day of ex-dividend trading by dropping exactly by the amount of the dividend just paid out. So, an investor essentially loses this first dividend and needs to wait for another one.
Please note that the fact that dividends can be paid out a long time after they have been declared makes absolutely no difference to our calculations, as by buying a stock at any time, the next dividend payment is always in the payout pipeline, regardless of how long ago it has been declared.
As an investor receives each installment of the dividend, he can either reinvest it or put it to another useful purpose. In other words, the dividend cash can continue to earn income from the time when it has been paid out until the end of the year. So, for one full year, the dividends will earn additional yield for the following number of months until the end of the year when they are compared with the capital appreciation for that year:
- Q1 dividend: 9 months
- Q2 dividend: 6 months
- Q3 dividend: 3 months
- Q4 dividend: 0 months
The 37.5% difference in annual return
Based on the above list, the average time each dividend earns extra yield is 4.5 months. This equals to 37.5% of the year, so the dividends earn an extra 37.5% of whatever annual yield an investor is able to generate. The least he should be able to generate is the dividend yield of the stock that paid out these dividends. Let's say the stock has a dividend yield of 2.5%, which is realistic, as the average for all S&P 500 stocks is just over 2% in the long term, and that includes approximately 20% of stocks, which currently pay no dividends at all.
The dividends paid out in Q1-Q3 together generate an additional 37.5% yield, which at 2.5% yield means an extra 0.94% interest. This brings the total annual rate of return to 3.44% at the end of the year, compared with just 2.5% that the capital appreciation would generate during the same time.
The 43% difference in return over 10 years
Demonstrating the stark contrast on a longer timeframe makes the difference even more profound. After 10 years of total returns solely made up of capital appreciation at a 2.5% annual rate, an investor ends up with a total return of 28%. So, $100 invested ends up being $128.
In contrast, in the case of dividend returns making up the entire capital appreciation (meaning there is zero capital appreciation of the underlying stock price, so the stock price remains exactly the same), the same dividend yield of 2.5% generates a 3.44% annual return, as we have shown above, and this compounds to a total return of 40.2%. So, a $100 investment returns $140.2 after 10 years, or 43% more than the capital appreciation.
In conclusion, the dividends-driven total return generated 40.2% total return in 10 years, whereas the capital appreciation-driven total return created just 28% total return after the same period of 10 years.
So, the dividend-driven return generated a 43% higher total return over 10 years than a capital appreciation-driven return of the same percentage, on the same amount invested, other things being equal.
This is the power of compound interest, which is the ultimate secret of dividend reinvesting. Note how even the already high initial difference in annual return of 37.5% increased over time to 43% due to compounding at a higher annual rate of return.
In conclusion, if an investor can find an equally "good" stock, meaning its intrinsic value is the same, he should pick the one paying a higher dividend yield, other things being equal, because a larger part of the total return on this stock will be realized through dividend payments, which generate higher total return than capital appreciation, all else being equal.
Great examples of stocks that generated most of their total return through dividends, and not capital appreciation, over the last decade are Microsoft (NASDAQ:MSFT), which paid $8 in plain dividends. That becomes $11.44, if compounded according to the calculations above. That is a 42.5% increase from the starting price. At the same time, Microsoft's stock appreciated by just $7.93, and that is after the recent $5 spike, for a total 29.12% price increase. Otherwise, it traded pretty much flat for the past decade.
Or, take General Electric (NYSE:GE). The share price dropped by 19% in the decade. But GE paid out $8.30 in dividends. If compounded, they represent a 41% increase of invested capital, so the dividends more than offset the loss from a falling price.
Merck (NYSE:MRK) is another excellent example. Its price fell by 14% to $47. However, Merck paid out a hefty $18.33 in dividends, which represents a 47% capital return. Again, the dividends, reinvested, more than offset the loss from a falling share price.
AT&T (NYSE:T) is a shining example from the telecom utilities. Its share price rose "just" by $10.5, or 41%, but the total dividends paid were 15.36. If reinvested, their contribution to AT&T's total return was 85.5%.
The above examples show the mighty power of compounding thanks to reinvested dividends. And there are many other stocks where dividends more than offset a stock price, which fell or rose just too little.
An excellent opposite example is Berkshire Hathaway [(NYSE:BRK.A), (NYSE:BRK.B)]. It never paid a dime in dividends. Yet, in the last decade, it returned 141.5% for an annual return of more than 9%. So obviously, it all comes down to the quality of the underlying stock. There are great returns to be made with or without using dividends.
Important limitations and factors to consider
There are multiple issues to consider before jumping to the conclusion that easy money can be made without any risk, and several caveats when using this specific strategy:
1. In the real world, it is hard to predict or find investments that will have a total return over a long period of time consisting only of the dividend yield and zero capital appreciation. So, investors should just try to seek out stocks that generate at least most of the total return via dividends.
2. An obvious conclusion would be to invest in stocks with very high dividend yields, even though these might actually lose value in terms of capital appreciation thanks to falling price. These stocks might have a higher risk profile, due to the dividend being suspiciously high, and the risk of their bankruptcy (total loss of capital) could be higher. So, it is important that investors stick to their basic investing principles, such as "return of capital before return on capital."
3. Further investigation is needed to determine whether this phenomenon is already priced in the current values of stocks. In other words, whether stocks of equal intrinsic value, but higher dividend yields, fall proportionally more in price, other things being equal, which would in effect negate partially or completely the benefits of higher returns realized through dividends as opposed to capital appreciation, because such stocks would lose more in capital than stocks with lower dividend payments.
4. Tax issues definitely have to be considered for each individual investor. Capital appreciation, as well as dividend payments, may or may not trigger different tax events at different tax rates, depending on what type of the investment account or vehicle is used and subject to the individual situation of each investor.
5. In Europe, the situation is different, because stocks often pay out dividends only once or twice per year. So, the compounding effect of dividend payments is not so profound over capital appreciation, or it is non-existent in the case of annual dividend payments.
6. On the other hand, in the case of monthly paying dividend stocks, the positive effect of dividends over capital appreciation is even more profound. These generate, on average, an extra 5.5 months of return, meaning the total dividend annual return is 45.8% higher than capital appreciation, compared with "just" 37.5% higher return in the case of quarterly paying stocks as described in this analysis.
7. There are many other factors to consider, including trading fees in some cases of dividend reinvesting, etc.