Dividends: Useless Without Price Appreciation

| About: International Business (IBM)

Summary

Recent commentary on Seeking Alpha has debated the worth of dividends.

Companies paying reliable dividends are excellent at creating income.

Without share price growth, the shareholders' wealth will not increase.

Dividends Alone Offer No Growth

My quest for investment return has led me to the wonderful world of dividend growth investing. I don't consider myself a true DGI however, since I don't always seek stocks with long dividend growth histories. If the company pays a dividend supported by its earnings and cash flow with a payout ratio below 50% of trailing twelve month earnings at around a 3% yield regardless of dividend growth history, I'm interested. A dividend growth history isn't as important to me as a sustainable dividend that isn't a large burden on the company. I don't consider a dividend to be a shareholder's right, rather it is the right of a company to choose to pay a dividend. Dividends are gifts from companies to shareholders, as a measure of gratitude and from a desire to reward shareholders.

Recently there has been some interesting discussion on Seeking Alpha about the contribution of dividends to total portfolio returns. I enjoyed the perspectives offered, and reading through the articles (forgive me if I missed a few) got me thinking. I feel that dividends alone fall short of the holy grail, and will be looking at an extreme case to explain my reasoning. Ultimately I consider dividends' wealth-growing potential maximized when accompanied with share price appreciation. Without price appreciation, the price of a company that pays out a dividend is decreased by the amount of the dividend. That is, no wealth is created by a dividend payment. A company with a $100 share price that pays a 1% dividend will pay out $1 and will decrease in price to $99 after the payout. After the dividend payment, the lucky shareholder that holds 1 share will still have $100. If the dividend were reinvested, our example shareholder would then own 1.01 shares and the total value would still be at $100. The end result: the shareholder will have no additional wealth unless the stock grows in price.

Stock Price and Net Wealth After Dividend Payment

Dividend Payment ($)

Price After Dividend ($)

Share Count

Net Wealth ($)

Reinvestment

1.00

99.00

1.01

100.00

No Reinvestment

1.00

99.00

1.00

100.00

Click to enlarge

That's only a generic example, but there are other examples that we can investigate more fully.

IBM's Dividends Offer Income Stream

For the next example, I'd like to turn the focus to International Business Machines (NYSE:IBM), one of my favorite dividend payers. IBM currently pays a 3.6% dividend with a payout ratio of about 36% based on ttm earnings. In my perspective, IBM offers both a strong dividend yield with a low payout, telling me that this company can easily afford its current dividend and will be unlikely to cut. Based on the low payout, I consider IBM more likely to raise its dividend than cut it. For this example it will be assumed that IBM's share price does not grow over 10 years and is only affected by dividend payouts. Reinvestment is assumed to be commission free and happens on an annual basis. An investor put roughly $10,000 into IBM, which netted 68 shares. IBM then maintained its 3.6% dividend yield for the remainder of the 10-year example.

IBM Dividends Over 10 Years With No Growth in Share Price

Year

Share Count

Share Price ($)

Annual Dividends ($)

Net Value of Investment ($)

1

68.00

147.09

360.08

10002.12

2

70.54

141.79

360.08

10002.12

3

73.17

136.69

360.08

10002.12

4

75.91

131.77

360.08

10002.12

5

78.74

127.03

360.08

10002.12

6

81.68

122.45

360.08

10002.12

7

84.73

118.04

360.08

10002.12

8

87.90

113.79

360.08

10002.12

9

91.18

109.70

360.08

10002.12

10

94.58

105.75

360.08

10002.12

Click to enlarge

Source: Author's Projections

Although IBM consistently paid out a 3.6% dividend that was reinvested into the stock, the annual amount of dividends paid did not increase. The company paid a constant 3.6% dividend of a share price that decreased 3.6% per annum (because of the dividend payment), while the share count steadily increased by 3.6%, netting constant income level and net value of the investment. Without share price appreciation, the net value of the investment (and the income level) stagnated.

Dividend Payment With Price Appreciation

When price appreciation is added into the picture, the outlook changes significantly. Using the same initial price and reinvestment criteria, this next perspective will assume that IBM's share price appreciates at 5% annually while still paying the 3.6% dividend.

IBM Dividends With 5% Share Price Appreciation

Year

Share Count

Share Price ($)

Annual Dividends ($)

Net Value of Investment ($)

1

68.00

147.09

360.08

10002.12

2

70.41

149.15

378.08

10502.23

3

72.91

151.24

396.98

11027.34

4

75.50

153.35

416.83

11578.70

5

78.18

155.50

437.68

12157.64

6

80.96

157.68

459.56

12765.52

7

83.83

159.89

482.54

13403.80

8

86.81

162.12

506.66

14073.99

9

89.89

164.39

532.00

14777.69

10

93.08

166.70

558.60

15516.57

Click to enlarge

Source: Author's Projections

Following the same 10 year period with a 5% annual share price growth, the net worth of the original investment increased by 55%. Not only did the net worth of the investment grow, the income from the investment grew by 55% as well. As expected, the price appreciation and dividend payment have a compounding effect.

Growing Dividend Payment With No Price Appreciation

A growing dividend can also affect the situation differently. For this next example it is assumed that IBM will grow its dividend by 10% annually over 10 years, while the share price does not appreciate and again is only affected by the dividend payments. Although the dividend and income grew, the investment net value stayed constant.

IBM Dividends With 10% Dividend Growth and No Price Appreciation

Year

Share Count

Share Price ($)

Annual Dividends ($)

Net Value of Investment ($)

1

68.00

147.09

360.08

10002.12

2

70.54

141.79

396.08

10002.12

3

73.45

136.18

435.69

10002.12

4

76.79

130.25

479.26

10002.12

5

80.66

124.01

527.19

10002.12

6

85.15

117.47

579.91

10002.12

7

90.39

110.66

637.90

10002.12

8

96.54

103.60

701.69

10002.12

9

103.83

96.33

771.86

10002.12

10

112.51

88.90

849.04

10002.12

Click to enlarge

Source: Author's Projections

Just for fun the next example will have IBM's share price shrinking by 5% annually while maintaining a 10% dividend growth. The income stream will continue to grow even while the share price and net wealth decrease.

IBM dividends with 10% dividend Growth and 5% Depreciation

Year

Share Count

Share Price ($)

Annual Dividends ($)

Net Value of Investment ($)

1

68.00

147.09

360.08

10002.12

2

70.68

134.44

376.28

9502.01

3

73.75

122.39

393.21

9026.91

4

77.30

110.94

410.91

8575.57

5

81.40

100.08

429.40

8146.79

6

86.18

89.80

448.72

7739.45

7

91.79

80.10

468.91

7352.48

8

98.39

70.99

490.01

6984.85

9

106.24

62.46

512.06

6635.61

10

115.63

54.52

535.11

6303.83

Click to enlarge

Source: Author's Projections

While the net wealth shrank and income grew, the share count also grew steadily. That being said, the dividend growth did nothing in terms of net worth to offset the shrinking share price.

More on IBM

A last example will go a bit beyond some contrived parameters. IBM's dividend has grown from $0.70 paid during 2004 all the way to $5.00 paid out during 2015, a compound annual growth rate of 18%. Over the same time, the share price grew from $92.45 on March 15th, 2004 to our above March 18, 2016 price of $147.09. This annual growth rate averaged 3.9%. Earnings per share growth (excluding any repurchases) from $4.94 to $13.42 reached 8.7%. These trends were assumed to continue over 10 years, beginning from the dividend rate of 3.6% and share price of $147.09.

IBM Dividend, Income, and Net Wealth 10 Year Projection

Year

Share Count

Share Price ($)

Annual Dividends ($)

Net Value of Investment ($)

1

68.00

147.09

360.08

10002.12

2

70.44

147.53

441.46

10392.20

3

73.44

147.02

541.24

10797.50

4

77.17

145.38

663.57

11218.60

5

81.82

142.45

813.55

11656.13

6

87.72

138.07

997.43

12110.72

7

95.27

132.08

1222.87

12583.03

8

105.10

124.39

1499.26

13073.77

9

118.14

114.98

1838.12

13583.65

10

135.83

103.91

2253.58

14113.41

Click to enlarge

Source: Author's Projections

The net effect of a rising dividend payout and rising share price portend well for both the income and net value of the investment.

Final Note

A stagnant dividend will neither grow net income nor net wealth. A growing dividend can grow income, but net wealth remains unchanged without any price appreciation. Falling share prices bring down the net wealth, regardless of any level of dividend growth. On the other hand, even a small amount of appreciation combined with a growing dividend compounds significantly. Since I'm younger and largely focused on growing wealth, dividends and dividend growth are not my sole concern. Investors seeking total returns should recognize that while dividends provide income streams, there will be no growth in wealth without share price appreciation.

Disclosure: I am/we are long IBM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am neither a certified investment advisor nor a certified tax professional, and do not claim to be either. The data presented here is for informational purposes only and is not meant to serve as a buy or sell recommendation. Investors and potential investors should do their own research and make their own decisions. In the event that an investor or potential investor does not feel qualified to make such a buy or sell decision on their own, they should consult a certified advisor that they trust or feel comfortable with. Investing may involve losses, including potential loss of principal. The author relies on external links for some information that may have appeared on this perspective. These external links, although believed to be accurate, have not been verified independently. Therefore the author is unable to guarantee their accuracy.