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Why should investors consider purchasing dividend-paying stocks? After all, they are boring investment vehicles offering little to no return, right? Not exactly.
Consider this: during a market downturn, if you bought a stock that pays a dividend, you are pretty much guaranteed a payout. I thought that would grab your attention. Furthermore, combine a consistent dividend with an increasing stock price and you can have your cake and eat it too. These are the types of companies that growth and income investors seek out. So, grab a fork and let’s explore the power of dividend growth.
Sharing the Wealth
When the Board of Directors, or the people who make decisions on the behalf of shareholders, decides to distribute a portion of its company's profits, it can do so in the form of a dividend. Companies are not required to pay dividends, but those that do, offer investors a level of growth over time that can prove to be quite lucrative.
An investor’s total return can grow handily over the years when a dividend is factored in. Remember that a stock’s total return consists of both price return and income return. Price return, or capital appreciation, is an increase in the market price of a stock. Income return factors in dividends.
A Bountiful Yield
A company’s dividend yield is defined as how much it pays out in dividends each year relative to its share price. The ratio is computed as follows:
Dividend Yield = Annual Dividends per Share/Price per Share
Let’s take a look at the two companies featured below—Penny Pincher Enterprises and Generous Corporation. Which company has the higher dividend yield?
Penny Pincher Enterprises
Annual Dividend: 25 cents per share
Share Price: $95
Annual Dividend: $2.00 per share
Share Price: $35
Okay, so that was an easy question—Generous Corporation’s dividend yield is 5.71% ($2.00/$35) and Penny Pincher Enterprises is yielding 0.26% ($0.25/$95). But the example helps set up the next comparison.
The Power of Dividend Growth
If you bought $10,000 of Penny Pincher stock, you can expect $26 each year in dividends. Compare this with $10,000 of Generous Corporation stock which would provide you with $571 per year.
The longer a company has been paying dividends, the more likely it will continue to do so going forward. Investors have come to expect this cash flow and if terminated, the company runs the risk of upsetting or even losing its investor base. Furthermore, a solid, dividend-paying company may increase its yield each year. That is music to investors’ ears.
Price Return + Income Return = Best Thing since Sliced Bread
The larger the dividend per share a company distributes to its shareholders, the more wealth they will accumulate over the years. Couple a steadily increasing dividend with small, yet stable growth in share price, and CHA CHING—you have hit the jackpot!
Growth and income investors look to capitalize on some combination of price appreciation and income return. They hope to experience growth during up markets and added protection, via dividends, in down markets. While these types of stocks may not be the sexiest on Wall Street, over the long term, they can keep an investor quite content.
We made it very clear in our article “The Power of Dividends” that an inves...
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