The following is a post by Kanwal Sarai, the founder of Simply Investing.
Dividends are cash payments made to shareholders. As a shareholder you are part owner of the company and therefore are entitled to share in the profits. Dividends can also help you determine when a share is undervalued, and priced right for purchase.
There are a number of other additional benefits to owning dividend paying shares, and I discuss my top five in this article.
1. Dividends provide an immediate return
Dividends provide an immediate return on your investment. Suppose you buy shares in company XYZ, where the dividend is $1 per share per year, and the share price is $20. $1 dividend divided by $20 gives you a 5% return. This means that if you bought $2000 worth of shares in company XYZ you would receive $100 in dividends (in cash) every year for as long as you own those shares, and as long as the company continues to pay the dividend. The dividend is paid regardless of the share price. The share price could go up or go down (in fact share prices fluctuate every day) but you will continue to earn 5% each year on your initial investment of $2000. The dividends are yours to keep, you can choose to spend the money or reinvest it into buying more shares. Without dividends you solely rely on share price appreciation, the gains are only made if you sell the stock for a profit, without dividends there is no immediate return on your investment.
2. Your safety buffer against the worst case scenario
Dividends provide a safety buffer against share price fluctuations or even the worst case scenario, where the company goes bankrupt and the shares become worthless. Remember once dividends are paid to you, they cannot be recalled or taken back; the dividends (money) are yours to keep. So even if a company goes bankrupt, the dividends you have received to date provide you with some cushion to help minimize your losses. If you owned shares in a company that did not pay dividends, and the company went bankrupt you would lose 100% of your money.
In a personal example I purchased $2479 worth of TRP (TransCanada) shares in 2000. Since then I have received $2475.26 in dividends, which almost equals my initial investment. By next year I expect to have earned over $2479 in dividends. TRP shares trade at around $43 today, but even if the share price dropped to $35 or $20, I’d still be making money because the dividends have provided me with a margin of safety against any losses.
3. Dividends increase over time
Over time financially healthy companies increase their dividend. But why is this important to you? It is important because it means more money for you! Let’s take a look at a real-life example and see what happens to your return as the dividends are increased over time:
Year - Dividend
2003 - $0.40
2004 - $0.55
2005 - $0.67
2006 - $1.00
2007 - $1.50
2008 - $1.63
2009 - $2.05
2010 - $2.26
2011 - $2.53
2012 - $2.80
Suppose you purchased 150 shares of McDonald’s in 2003 for $13.34 each: 150 shares*$13.34 = $2001 initial investment.
Yield on Cost = Current Dividend / Stock Purchase Price: Yield on Cost = $2.80 / $13.34
Yield on Cost = 21%.
After ten years you would have earned 21% based on your original investment of $2001. In ten years your return on $2001 has gone from 3% to 21%, and all you had to do was hold on to those shares. McDonald’s has increased their dividend every year since 1976!
Here’s a list of some other companies and the number of years of consecutive dividend increase:
Abbott Labs (ABT), 37 years
Coca-Cola (KO), 48 years
Johnson & Johnson (JNJ), 48 years
Proctor & Gamble (PG), 56 years
(Disclaimer: My Own Advisor owns all four of these companies).
That’s consecutive years of dividend increases, dividends increased every single year during the following disasterous events: 9/11, the Iraq war, the credit crunch, the bailouts, high unemployment, the Euro crisis….and so on. Now I can’t predict the future, but I have a high degree of confidence that companies like MCD, ABT, KO, JNJ, and PG will increase their dividends next year or at the very least maintain their current dividend.
4. Dividends have a long history of being paid
Some people will argue that dividends are not guaranteed, and that companies are under no legal obligation to pay dividends. That’s true. However, quality, financially healthy companies not only increase their dividends over time but they also have a long history of paying dividends. Companies know that a dividend decrease will result in a decrease in the share price, which is exactly what they don’t want. So quality companies will crunch the numbers, and verify the numbers to ensure that they can continue to pay dividends, and continue to increase dividends over time. A dividend increase is a positive sign that the company believes that they have the financial resources to continue to pay dividends.
Here’s a list of some Canadian companies that have been paying dividends for a very long time:
Bank of Montreal, since 1829
Bank of Nova Scotia, since 1833
Toronto-Dominion Bank, since 1857
Royal Bank of Canada, since 1870
BCE Inc., since 1881
Fortis, since 1949
Enbridge, since 1952
(Disclaimer: My Own Advisor owns most of the companies above).
5. Dividend yield can help you determine when to buy
You may have heard of the term “buy low, sell high” but how do you know when to buy low, how do you determine when a stock is undervalued? Using dividend yield you can determine if a stock is undervalued or overvalued. Let’s take a look….
I’ll continue with our example of company XYZ, where the dividend is $1, and the share price is $20. Now suppose that the stock price drops to $15 or $8. What happens to the dividend yield?
Dividend / Share Price = Dividend Yield
$1 / $20 = 5%
$1 / $15 = 6.7%
$1 / $8 = 12.5%
Notice as the share price decreases the dividend yield goes up. All things considered equal is it better to buy the shares at $20 or $15 or $8? In this example, $8 would be the best price to pay for the shares because you would be earning 12.5% on your investment! Remember as the share price goes down the dividend yield goes up, and as the share price goes up the dividend yield goes down. You want to buy shares when the stock price is historically low.
Suppose the average dividend yield for company XYZ is 4.5%, the shares are then undervalued when the current dividend yield is higher than the average dividend yield. If the current yield is 9% you can be sure that the shares in company XYZ are undervalued and worth considering. If the current dividend yield is 2%, the shares are overvalued. This example demonstrates it is important to consider the average dividend yield for a particular stock before purchase.
There are other factors to consider before making a stock purchase decision, but checking the current yield against the average dividend yield should be the first factor to consider; actually it’s very important to me. Since I started the value investing approach I have never purchased a stock when its current yield was lower than its average yield. This first step alone has saved me thousands in losses, and has provided me with thousands in gains. You can do the same with your investments if you remember to buy quality dividend paying companies when they are undervalued.
Kanwal Sarai, is the founder of Simply Investing, and on a quest to bring financial freedom to all. He created the Simply Investing Online Course on the belief that the world can be a better place if people didn’t have to worry or stress out about money. Simply Investing’s goal is to make investing easy, save you time, and help you safely earn more.
Thanks to Kanwal for this post and his on-going support of My Own Advisor.