Frontier Communications Corporation (NASDAQ:FTR), having just closed at $4.04 this past Friday, continues to find new lows. While its performance is disappointing shareholders and delighting short sellers, it at least provides a great opportunity to make a couple points about dividend reinvesting. I've written previous articles about transforming small amounts of money into million dollar sums through dividend reinvestment. The clear caveat is that you have to pick the right stock or, more broadly, the right securities. FTR's track record is currently disqualifying it from consideration.
Dividend reinvesting is not an automatic path to greater wealth, it simply compounds the existing stock return, which includes both dividends and share appreciation. The first point is about return which includes dividends and share appreciation. For a dividend investor to ignore capital appreciation, or more importantly, depreciation is dangerous. I have yet to see a stock that trades at zero pay a dividend, and they usually stop paying the dividend long before that. The second point is compounding which makes positive returns more positive, but also it makes negative returns more negative.
Frontier has been a terrible investment
The following graphs using FTR performance from January 2009 will clearly illustrate these points on both a pre-tax basis and after tax basis. On January 2, 2009, FTR closed at $8.81 per share. Its quarterly dividends were $0.25 per share giving it a high yield of 11.4%. Since then, the stock has collapsed to $4.04 per share. FTR has a quarterly dividend of $0.1875, implying a stratospheric forward dividend yield of 18.6%. This is a 16.6% premium to the 10 year treasury bond. The first graph shows the pretax return of simply purchasing the stock on January 2, 2009 and selling this past Friday. All returns calculated here use an Internal Rate of Return calculation.
Source: TCB Capital Advisors, LLC Note: returns are calculated as Internal Rate of Return.
So dividends are pretty helpful in limiting the impact of capital depreciation. But overall this is a terrible return. In comparison, the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) provided a total return of 14.8% with 2% of that from dividends. Just looking at dividends on FTR might make you happy, but it is not the complete picture. The capital loss more than offsets those dividends.
The next graph looks at these returns on an after tax basis. Tax payment timing is assumed to be at the time of dividend with capital gains or loss taxes set at the following year in April.
Source: TCB Capital Advisors, LLC
As one would expect the total returns look better on an after tax basis, while the return from dividends is smaller. Since there was a capital loss, the timing of the tax benefit from that loss is important. It is important to not forget the benefit from the capital loss, ignoring it would push the return below -12%.
However, what happens if dividends are reinvested back into FTR? The returns should decline because the dividends are being transformed into stock that is declining into value. The following chart shows these pretax returns.
Source: TCB Capital Advisors, LLC. Note the total return is a direct calculation, while the allocation to capital and dividends has some estimations. The return from dividends on the DRIP will be better than the 11.6% return posted in the no DRIP scenario by the approximate ratio of dividends earned from reinvested dividends which is about another 17.8% increase in total dividends received. 13.7% = 1.178 x 11.6%
So this illustrates the second key point. Total returns are worse with DRIP if the stock is declining - i.e., capital depreciation. Once again the after tax view will be an improvement since there is a tax benefit from the capital loss, while there is a tax liability from all the dividends. The internal rate of return is -6.8% assuming tax benefits and losses occur at the time of income realization.
I think this makes the point that when looking at investments one has to consider both the dividends and the potential share appreciation. Looking at just one will distort the picture. Furthermore, DRIPs can be useful to the investor, but it is not a way to increase returns, but rather a way to magnifying existing returns.
But IRR is actually a terrible metric...
This article has a third more subtle point that relates to the mathematics of IRR calculations and the impact of reinvestment. In the cases without DRIP there is a question about what you do with the dividends received. The IRR calculation assumes that they are reinvested at the same rate as the IRR, which in this case is hopefully incorrect. So if you just stuffed those dividends into a mattress and waited and put those cash flows at the end when you sell the stock the return improves to just -8.6% (which is still a disaster). However, in the DRIP calculations, the IRR is actually closer to being "accurate" since there dividends are actually reinvested. The DRIP pretax return of -12.7% should really be compared to the -8.6% which more clearly illustrates the compounding impact of dividend reinvestment.
So in any situation, when someone shows up with an investment opportunity (e.g., stock, capital project, etc..) with a great IRR, ask to see the underlying cash flows. If there are some large positive early cash flows and then smaller ones further into the future, then you should be skeptical since most likely you will not earn that IRR as a return on the initial investment over the life of the project.
Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.