In order to fully commit to anything, whether it is a diet or an investment plan, it is important to see the reward at the end of the road. When making these decisions we evaluate whether the pain is worth the reward, but if we perceive that the pain in the present is greater than the reward in the future we will most likely quit. In order to commit to an investment plan you need to see the reward on the other-end. The pain is saving money instead of spending it and dealing with the ups and downs of market cycles. The reward will be illustrated in this article as we look at the value of building a dividend income stream.
There are two ways to make money by owning stock: Buy, then sell for a higher price, or get paid a dividend for owning the stock. For this article we will be focusing on dividends. A dividend is a cash distribution paid by a company to the owner of stock. Dividends may be paid quarterly, semiannually, annually, or a one time non-reoccurring payment. Dividends can be taken as cash or reinvested into more stock. Dividends are paid per share of stock owned. So if you own 100 shares of stock XYZ, and XYZ pays an annual $2.00 dividend you would receive $200. If XYZ decided to pay a $3.00 dividend the next year you would collect $300. The board of directors decides when and how much of a dividend to be paid.
Dividend yield tells you what interest rate the investment is yielding. If you paid $50 per share for XYZ, and it pays a $2.00 per share the dividend yield would be 4% (2 divided by 50). Note that if the price of XYZ stock falls to $25, and XYZ pays the same $2.00 dividend, the yield would go up to 8%. In contrast, if XYZ rose to $75 the yield would fall to 3%. The market price of a stock has no bearing on the amount of dividend paid; only the company's financial ability to pay and the board of directors decision effect dividend payments.
So, Who Cares
You might be thinking $200 a year is not something to get very excited about. And you are right, $200 a year is not nearly enough reward to compensate us for the pain of investing, but let's keep in mind that you have only invested $5,000 in the above example ($50 stock price multiplied by 100 shares). Instead imagine you invested $5 million. That would give you 100,000 shares with a $2.00 per share dividend would be $200,000 year, which is something you could start getting excited about.
I Don't Have 5 Million Dollars
For those of you with $5 million in the bank, congratulations, but if you do not have this type of money, investing each year over a series of years can prove valuable. Starting early can help you realize big dividend payments later in life, and we will illustrate this strategy with looking at the history of McDonald's.
McDonald's made their first dividend payment in 1976. We will pretend that we made a $5,000 investment at that time, and we will continue to invest $5,000 each year on the first trading day of May. Looking at the historical records, we can see how much each share of McDonald's was selling for at our May buying date, and calculate how many shares $5,000 would have bought us each year. By implementing our plan we would have accumulated 42,263 shares of McDonald's by the end of 2011. This figure is taking into consideration stock splits and not reinvesting the dividends. In 2011, McDonald's paid a quarterly dividend of 70 cents per share. That gives the investor a quarterly dividend payment of $29,584, totaling $118,336 annually. Not too shabby, right? Here's the most important part: you have only invested $175,000 in total (35 years multiplied by $5,000). Remember in the example above when you invested 5 million to realize a $200,000 dividend payment? Would you rather invest $175,000 and make $118,000 a year or invest 5 million to make $200,000? I think the answer is clear. Even though $200,000 a year is more than $118,000 you would have to save and tie up an additional $4,825,000 to realize the extra income. That is a lot of money to tie up, and more importantly, a higher exposure to market risk.
So how is this possible that we can get such a big dividend payment out of a relatively small investment? The answer is McDonald's has increased their dividend payment each year since 1976. So back in 1976 when you invested $5,000 it bought you 81 shares, and at that time McDonald's was paying a dividend of $0.10 per share, multiplied by 81 shares gives you an annual $8.10 dividend payment. Nothing too exciting there, but each time McDonald's increases their dividend the 81 shares you bought in 1976 become more valuable. Furthermore, McDonald's stock split 7 times meaning the 81 shares you bought back in 1976 multiplied to 3,280 shares today. Your original investment of $5,000 in 1976 gives you 3,280 shares of McDonald's stock, multiplied by the $2.80 per share 2011 annual dividend, equals $9,184 of annual dividend income today. To restate, your one time investment of $5,000 is yielding $9,184 a year. The 81 shares you bought in 1976 are becoming more valuable each time McDonald's increases the dividend, and therefore when investing we want to seek out companies that pay a dividend and have a history of increasing their dividend.
Growth and Dividends
As a company increases their dividend the stock tends to become more valuable as well because it is yielding more to the investor. This tends to increase the market value of the stock as investors are hunting for that yield. In the case of McDonald's, our $175,000 basis would grow to $4,208,975, a nice added benefit. (Assuming no dividends were reinvested. Excluding fees. No capital gains taxes due because we never sold the stock.)
Dividends help you keep a cool head in times of crisis as well. We all remember back in 2007 and 2008 when all asset classes took a sharp decline. Many companies will experience declines in their market price, but at the same time increase their dividend payment. This was the case for McDonald's through the financial crisis. McDonald's continued to pay a $1.5 annual per share dividend in 2007. And in 2008, during the most volatile market conditions in decades, the company raised the dividend to $1.63 per share. In our example, our dividend payments in 2007 and 2008 would have been $60,825 and $66,233, respectively. These cash inflows help us keep a cool head when the market is in crisis. As stated earlier, the market price of a stock has no bearing on the dividend payment, only business fundamentals. In times of crisis if the business fundamentals are sound, and dividend will be paid, a dividend investor will keep a cool head instead of panicking and selling at the bottom.
Another point of crisis for the markets was from 1999 to 2003 during the Tech Bubble. McDonald's stock lost 68% of it's market value during that time. In our example, you would have lost roughy a million dollars of market value. Your balance would stand close to $700,000. You invested $135,000 at this point, so you would still have gains, but would you be able to keep a cool head? Would the dividend help you manage the crisis? There is no way of answering those questions, but what I can tell you is that if your strategy was share accumulation for the purpose of an income stream you would have noticed McDonald's increased their dividend each year from '99 to '03. And not just small dividend increases. From '99 to '03 McDonald's increased their dividend over 100%. When the stock price is falling and the company is increasing the dividend it creates an enormous buying opportunity that if taken advantage of could create enormous wealth. And McDonald's did just that, going from $16 a share in 2003 to over $100 a share at the end of 2011 while continuing to increase the dividend each year.
In normal market conditions dividends help put a "floor" on how low a stock will go until new investors will be attracted to buy. As illustrated earlier, as a stock price falls the dividend yield increases, making the stock more attractive. If you follow some of the strongest dividend payers you will notice an imaginary floor that the market will not let it go under. There comes a point when the dividend is just too attractive to pass up, and investors come flocking in to lock in their yield. In doing so they stabilize the stock price. The more stable investors perceive the dividend to be the less they let the stock price fall
Ok, I have cherry picked a company that has done very well, and every thing in hindsight is 20/20. So lets talk about the risks involved. There could be a circumstance when a company loses market value and the dividend is decreased or not paid at all. Let's take a look at Citigroup from November 1977 to the end of 2011 for a perfect example of what could go wrong. We will use the same assumptions: $5,000 invested each year and no reinvestment of dividends. For Citigroup we will make the investment in the first trading day of November. By November 2006, we would have accumulated 36,252 shares, and in 2007 we would be receiving a quarterly dividend of $0.54 per share. Quarterly income would equal $19,576, $78,304 annually. Your account balance would be around $2.3 million. However, after paying the quarterly dividend on November 21st, 2007 Citigroup's balance sheet and cash flow rapidly started to deteriorate due to the housing crisis. Management would have to start selling assets, raise capital, and cut the dividend to survive. The dividend was first cut in February 2008 from $0.54 a quarter to $0.32. A 41% cut. Next cut would be in November 2008 to $0.16. Then to $0.01 in January 2009. Finally, suspending the dividend all together in the Spring of 2009. In summary, you would have went from realizing a $78,304 annual dividend and account balance of $2,300,000 in November 2006 to no dividend and a account balance of $190,000 three years later in November 2009. Ouch.
You can do a few things to protect yourself from catastrophe like this:
Be well diversified. Do not rely on one stock to carry you throughout your life. Use the accumulating dividend strategy, but buy several different stocks in varying industries and sectors. When one sector goes bust, like banking in 2008, you can rely on the other companies in your portfolio to get you through the tough time.
Do your homework. Follow the companies in your portfolio by listening to the quarterly conference calls, subscribe to the company email alerts, and read the analyst reports of each company.
If you do not want to take the time, or do not have the time to do the homework hire a professional to do it for you. In the Citigroup example, an advisor is being paid to notice a 41% cut of the dividend in February 2008, and understands that it is an enormous red flag and hopefully alerts you to run for the exits.
In the End
I hope this illustration has brought attention the value in investing for dividends rather than simply focusing on capital gains. Not to say that investing for capital gains is a bad idea, but to point out a strategy that has merit in your portfolio. The dividend accumulation strategy can give you passive income and capital gains, while typically being more stable than investing in companies that do not pay a dividend. Commit to dividend paying companies now in order to reap the benefits in the future.
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