There is always some risk in any decision you make in life. There are also risks in putting your hard earned money in companies who regularly increase distributions. Investing in dividend paying stocks could potentially result in the risk of permanent capital and income loss.
However, the reality for the average dividend paying stock is less than grim. This is because for the price of dividend paying stock, an investor receives a junior claim to the assets of a company, along with their proportionate share of profits until the end of the world. In simple words, the most you can lose with dividend paying stocks is the amount of funds you put "at risk". However, as a dividend investor, you would likely receive dividend checks for years to come in most situations. These checks are essentially serving up as rebates on your cost, and ultimately reduce the cash amount you have put at risk in that particular investment. At the same time you still have your investment, meaning that you are essentially having your cake and eating it too. You can also use this cash that was distributed to you to acquire other income generating investments of your choice, or to spend it as you wish. Therefore, while the risk is limited, your reward is unlimited.
For example, if I purchased shares of Realty Income (NYSE:O) today, I would have to pay $40/share. I would generate a yield of 5.50%, given the current annualized dividend of $2.182/share. The dividend is paid monthly at a rate of $0.1818542/share. This means that every single month, I would receive a rebate for my investment, equivalent to slightly less than half a percent.
If I simply let that money accumulate in my brokerage account for ten year, I would end up with a share of Realty Income plus approximately $21.82 in cash. This example means that by the mere act of doing nothing other than recognizing a quality asset that pays me to hold it, I would end up recovering more than half of my purchase price, without losing my share of any future claims against from asset. Yes, please read that last sentence again - I would have not only recovered half of my initial investment in the company by November 2023, but I would still own the claims to my share of future rent checks until Judgment Day.
Of course, if history is any guide, Realty Income would likely keep increasing dividends at a rate of 3% - 4%/year over the next decade. This means that the cash I receive over that period of time would be slightly more than $21.82/share.
If the dividend remained stagnant, after 18 years I would have received dividend rebates which are equivalent to the amount I paid for the shares in the first place. The stock price might go down to $20 or up to $80/share but I would not care about these stock price fluctuations even for a single second. This is as long as the underlying fundamentals are strong, and the company manages to generate sufficient stream of free cash flow from thousands of properties in the US in order to keep showering me with cash on a monthly basis.
Of course, the drawback of my analysis is the fact that $1 today has a greater purchasing power in comparison to a dollar ten or twenty years from now. However, if a company like Realty Income can manage to boost distributions over time and match the rate of inflation, if can provide a 100% return of investment in less than 18 years (while still owning that investment, and being able to allocate those dividends received elsewhere, therefore earning more dividend checks etc).
Another item to consider with long-range forecasts is their fallibility. However, if you find a company which can reasonably be expected to deliver growth over the next 20 years, holding on to this stock could be a very rewarding endeavor. This growth could materialize due to catalysts known today, such as demographics, health or other factors. For example, Coca-Cola (NYSE:KO) is expected to earn $2.10/share in 2013. The company pays an annualized dividend of $1.12/share, which this dividend king has raised for 51 years in a row. If Coca-Cola manages to grow dividends by 7%/year over the next 2 decades, one could reasonably expect a dividend payment of approximately $4 - $4.50/share by 2033. If earnings per share followed a similar trajectory, Coke can reasonably be expected to earn $8 - $9/share by 2033. By applying a P/E range of 15 to 20 times earnings, this could translate into a stock price of anywhere from $120 to $180/share by 2033, as well as cumulative dividends of almost $50. Growth for Coca-Cola will likely be generated from the rapid increase in number of middle-class consumers in developing countries in the world, which would quench their thirst with one of the several hundred branded drinks that Coca-Cola Company offers.
Therefore, while an investor in Coca-Cola would have likely recovered their purchase price today exclusively from dividends alone, they should also not forget about the potential of capital gains. In the case of Coca-Cola, if my amateurish projections turn out to be closer to reality, investors could end up with a gain in net worth that exceeds the amount recovered through dividends.
All of the examples above do not take into effect the powerful nature of compounding. For example, let's assume that you invested $100 today and earned a total return of 10%/year for 25 years. At the end of the period you would essentially generate as much in total returns in a year as the amount you initially invested.
Another risk with my analysis comes in the case of corporate failure. It would be much safer to generate your dividend income from many dividend paying companies, as opposed to just a few. That way, if one of these companies cuts or eliminates distributions when it falls on hard times, your overall dividend income would not be at a great risk. If you build an adequately diversified portfolio of at least 30 individual securities, chances are that the dividend income from this portfolio is much safer than the income from your day job. This is because if you are relying on just one company for income in your day job, but thirty or more companies for income with dividend investing.
Therefore, investors need to be very careful in their stock selection processes. For example, I learned from Warren Buffett to try and guesstimate 20 years into the future and try to decide if I believe the business I am investing in will still be around. It would be much easier to decide that companies like Nestle (OTCPK:NSRGY), Coca-Cola or General Mills (NYSE:GIS) will be around in 20 years, because their products are characterized by repeated sales to customers, predictability of cashflows and pricing power. I cannot tell you however whether Apple (NASDAQ:AAPL) or Samsung will be around in 20 years. After all, BlackBerry (NASDAQ:BBRY) went from being an $80 billion company in 2008 and the leader in smartphones, to a former shelf of itself within five years.
Disclosure: I am long O, GIS, OTCPK:NSRGY, KO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.