In the comment sections of my articles, several investors have claimed that they do not care about capital appreciation. Many express the view that the dividend payments are the only thing of value in a stock. Indeed, one reader even went so far as to express it in this way: “A stock that pays no dividends is just a worthless piece of paper in someone’s vault.”
Most dividend investors do not take this sort of extreme stance. However, some do, and others seem to sympathize with this sentiment to varying degrees.
Therefore, I thought it might be interesting for illustrative purposes to quantify exactly how valuable dividends are to a stock as opposed to the resale value of the same stock in the future.
To this end I will pose two questions:
- What percentage of the current value of a stock can be attributable to its projected dividends?
- How long would it take an investor to “break even” on an equity investment assuming that the investor could only receive dividends?
For purposes of this exercise I make the following assumptions. In year zero, a stock trades at $20.00 per share, and is fairly valued at that price. The company pays an annual dividend of $1.00 per share in year one - a dividend yield of 5.0%. I assume a dividend growth rate of 5% per annum. A discount rate (cost of equity capital) of 10.0% is applied.
The Value Of Projected Dividends
How much are the projected dividends of our hypothetical company worth? Well, it depends, to a significant extent, on how long the forecast period is. The forecast period is the period of time for which dividend payments can be projected, with a reasonable degree of accuracy.
How many years worth of dividend payments can one accurately project? This depends largely on the type of business(es) that a company is engaged in. Typically, forecast periods cannot be reasonably extended beyond five years. In the case of companies with unusually stable cash flow streams (e.g. utilities) longer rage forecasts can be made. However, even in the case of such companies, forecast periods of longer than 10 years tend to strain credulity.
So what is the present value of five years worth of dividends for our hypothetical company, taking into account that it will grow dividend payments by 5% per annum? The net present value is $4.36 or 22% of the current share price of the company. The other 78% of the value of the company is derived from its “terminal value” – i.e. the projected value of the company if sold after receiving the dividend at the end of year five.
The present value of 10 years worth of dividends is $7.81, or 39% of the share price of the company. In this case 61% of the current share price resides in its terminal value or the projected resale value of the stock ten years from now.
What can we learn from this? Only a relatively small percentage of a company’s value is attributable to the value of its projected dividends. The vast majority of a company’s value tends to be related to its terminal value - including the implicit projection of the capital appreciation of the stock between the time of its purchase and its sale.
How Long Does It Take To Break Even On Dividends?
I have often heard the claim made that the value of dividends received from an investment in a dividend growth stock can very quickly exceed the value of the initial investment. Thus, according to this view, it really does not matter if the stock price eventually declines and/or even goes to zero.
I’m afraid that this notion is a bit of an urban legend.
To illustrate let us inquire how long it takes for an investor to “break even” exclusively via collection of dividends.
If we assume a discount rate of 10%, it takes 66 years in order for the present value of the dividend stream starting at $1 and growing at 5% per annum to equal the initial investment of $20.00. But this begs a question: Can anybody reasonably project a dividend stream 66 years into the future?
What about just breaking even in real, or inflation-adjusted, terms? Assuming an inflation rate of 3.0% per annum it would take an investor 17 years to reach the “break-even” point. In other words, for a fairly valued stock that currently yields 5.0%, it takes 17 years of dividend payments growing at 5% in order to simply recoup the inflation-adjusted value of the initial investment.
The clear message that should be derived from this exercise is that dividend investors should not be indifferent regarding the capital appreciation prospects of that “piece of paper in someone’s vault.” In the end, unless holding periods are extremely high, the majority of the value from an investment in a stock will tend to come from the capital appreciation.
Most dividend investors recognize that capital appreciation is important. However, I think that many do not appreciate just how big of a role capital appreciation plays in the total picture.
Projected dividends only represent 22% of the value of a company after five years of dividends growing at a rate of 5.0%; they represent 39% of the company’s present value after 10 years.
This means that for the majority of investors, realized capital appreciation in stocks such as opposed to accrued dividends will be the primary driver of total investment return. This is true even of “dividend stocks” such as AT&T (T), Verizon (VZ), Pepsi (PEP) and Procter & Gamble (PG) that sport higher yields than the average of the equity market (^SPX, ^DJIA, ^IXIC, ^NDX, SPY, DIA, QQQ) as a whole.
Another way to comprehend the same basic facts is to realize that for an investor that purchases a stock with a 5% dividend yield and a 5% projected annual growth rate, it takes 17 years to “break even” after inflation. It takes a whopping 66 years to produce economic value added if only dividends are taken into account.
Dividends are important. So are retained earnings and capital appreciation. Dividend investors should not focus on one to the exclusion of the other.
Fortunately the two forms of return are not mutually exclusive; they usually go together. They usually go together because they have a common source: Free cash flow. The importance of free cash flow as a driver of both dividends and capital appreciation will be the subject of future articles.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.