Dividends are often disregarded by stock investors. Some investors buy stocks purely for capital gains. Not only traders, but also many long-term investors share this disposition.
With a yield around 2%, dividends seem tiny, just as much as a government bond yield that reaches maturity in 10 years.
So, why dividend is still an integral part of investing? For long term investors, dividend should be an important thing, because:
1. By reinvesting the dividends, shareholder�s return will be optimum. Dividend income can be used to buy stocks continuously so that you add ownership in a company every certain period of time
2. By investing in companies that pay dividends (and still grow their profits), the future yield on our early investment will be higher than present yield.
The Magic of Reinvesting
Over the last 100 years (1915-2015), investment in S&P 500 companies showed that price return was only 5.52% per annum, where $1,000 in the year 1915 would become $215,700 in the year 2015. Had we reinvested the dividend we received, our fund would have become $12,116,800 translated to 9.86% annual return!
From that $1,000, the dividend received in 1915 would be $43, or yielding 4.3% (43/1000). In 2015, the dividend received would be $251,691 or yielding as much as 25169% from the original investment. Even without reinvestment, dividend received in 2015 would be $4,554 or 455% yield on the original investment.
If you think 100 years is too long, assume that you invested $1,000 for 20 years with the same rate of return mentioned before. The result would be $2,928 without reinvestments and $6,558 with reinvestments.
Dividend Yield: Now and Then
Let's say you invest $10,000 into a hypothetical company called Another Bingo Company, Inc by buying 1,000 shares, each at $10 per share. It has a P/E ratio of 12.5 (earning per share or EPS is $0.80) and a dividend payout ratio of 10%, which amounts to a dividend of $0.08 per share, giving you a total dividend of $80. You receive less than 1% of your investment as dividend, or only 0.8% yield.
The next 10 years, earning is $2.50 per share, generating a 12% compound annual growth rate. Because of stronger cash flow, then the company sets the payout ratio at 20%; therefore, the dividend per share is now $0.50. You are now receiving a total dividend:
1,000 shares x $0.50 = $500. That�s a 5% yield on your original investment.
The company is still growing. Not only the company increases the payout ratio to 30%, it also buys back shares so the total issued shares are decreasing.
Now the dividend yield on your original investment is 21%.
From table below, it is known that hypothetical company�s earnings per share (EPS) grows faster than total profit, caused by shares buybacks; and dividend grows more than EPS, caused by increasing payout ratio.
More Shares
By reinvesting dividends, investor owns more shares in the future. Stock price appreciation makes that additional shares even more compelling, leading to a significant difference on investment results.
Conclusion
Dividend plays a major role in shareholder's value creation. This is because the reinvested dividend income can be used to buy stocks continuously � increasing the number of shares that you own � in the hope of stock price appreciation in the long-run.
Dividend yield which seems low at the present can give a much higher yield in the future compared to our initial investment. This what makes dividend yield of a stock differs from yield of a bond. When a company or government issues a bond with 2% annual interest, that�s what you are receiving next year or even 10 years from now: the rate of return is constant. But when you make a 2% dividend yield at the 1st year of investing in a company, it is possible that you are getting 5% or 10% yield after several years of investing in that company.
Although dividend is important, companies without any dividends are not necessarily deemed unprofitable. It may be that the company is in a rapid growth phase so that the profits are used for business expansion (e.g. to purchase machinery or acquire other companies).
