Don't Spend Your Dividends
What Are Dividends and Payout Ratios?
With interest rates at historic lows and increasing volatility in major stock indexes, dividends have become the rallying call for investors. Blogs devoted to dividends proliferate and investors believe that dividend stocks are the best equity investment. Don’t get me wrong, dividends are fine, but just because a stock pays a hefty dividend does not mean it is a great investment. And the dividends the stock throws off are not “free money”.
What is a Dividend?
Dividends are earnings a company is electing to pay to the shareholder in lieu of reinvesting in the company. If the company does not pay a dividend, the earnings are used within the company to fuel growth initiatives, which if successful, will lead to higher share prices. If a company pays out a portion of those earnings, they are communicating that they believe you have a better use for those funds than the company does.
Wait a minute. Dividend paying companies are out of growth ideas?
Not exactly, usually dividend paying companies are older more established firms with a decent track record. These companies are confident that they will continue to grow into the future and decide to allow shareholders to participate in their profits now instead of waiting until the shareholder sells their stock to benefit.
What Is a Dividend Payout Percent?
Dividend payout percentages or the percent of net income that is paid out as a dividend varies. Back in the dot com boom of late last century, investors didn’t care about dividends nor did they flock to high dividend companies. The reason was because of a (mistaken) belief that the economy was transformed and beginning a new era.
In 1999, the S & P 500’s dividend yield was at a low point of 1.14 percent. Investors believed that with the advent of greater technology, stocks would grow and share prices appreciate faster than in the past. Thus, investors wrongly thought, “Who needs a dividend if the stock price is appreciating 15 to 20 percent per year?”
After the bursting of the technology bubble in the early years of this century, investor’s clamored for dividends. During the 2000-2002 bear market, when stocks fell 47 percent, the payout ratio reversed.
Today, investors love dividends, and companies comply by offering larger proportion of their net income back to investors. According to Ron DeLegge of ETF Guide, dividend payout ratios are at 31.8 percent, the highest level in 15 years.
Whether a company pays a dividend or not does not make that firm more or less profitable. The sales and growth of that company, along with wise use of its resources is what creates shareholder value. A dividend is not “free” money. A dividend is part of the profits of the company. If you spend your dividends instead of reinvesting them, you are giving up a grand opportunity to multiply your wealth.
Why You Shouldn’t Spend Your Dividends?
Let me preface this statement by saying, if you are in the retirement phase of your life and living off of your investments, there is absolutely nothing wrong with spending your dividends. This message is directed at those in the accumulation phase of their lives and building their net worth.
Dividend Reinvestment Case Study
Marlon holds shares in Awesome Industries. He bought 100 shares at $10.00 per share, for a total outlay of $1,000.00. Awesome pays a 1.5% dividend. Annually, Marlon receives $15.00 from his investment in Awesome.
If Marlon spends that $15.00 per year, that’s it, the money is gone!
If Marlon is a savvy guy and decides to reinvest his dividends and use them to purchase more shares he’ll have a lot more cash at the end of 10 years. Assume that both the company and its dividends grow at 7% per year.
After 10 years, at 7% annual growth, if Marlon spends his dividends, his stock is worth $1,967.00.
But Marlon decides to reinvest his dividends each year in more shares of Awesome.
At the end of 10 years, Marlon’s initial $1,000.00 investment is worth $2,282.60. For an annual compound rate of growth of 8.6%.
By reinvesting his dividends, he earned an additional $315.60 or 1.6% annual return.
Reinvest your dividends and your money will make more money. Spend your dividends and the money is lost. Reinvesting dividends over the long term is one of the best ways to build substantial wealth.
For those with dividend income, do you spend or reinvest?
A version of this article was previously published.