The Real Secret of Dividend Investing

 

In 1917,  the Dodge Brothers, John and Horace, sued the Ford Motor Company because they wanted a dividend.  Two years later, a final Judgment was entered in favor of the Plaintiff shareholders in the amount of $19.3 million.   The Michigan Supreme Court looked past Henry Ford's argument that he wanted to put "the greatest share of our profits back in the business" and held that "[a] business corporation is organized and carried on primarily for the profit of the stockholders."

There are essentially three ways to value a business.  All of those methods involve multiplying either the earnings, the revenues, or the dividends by a factor.   The factor varies based on the type of business and the prevailing interest rates.  

Frequently when valuing a private enterprise like a pizzeria or a parking lot, the multiplier is applied to revenues.  A dry cleaner, for instance, might sell for 70-100% of annual revenues; while a liquor store will only fetch 5% of annual sales plus inventory.

It is common when looking at stocks to value the stock based on a multiplier of earnings.   We call this multiplier the P/E or Price/Earnings Ratio.   A stock selling for $36 a share with $3.00 a share in earnings would have a P/E Ratio of 12 (12x3=36).   Arthur J Gallagher, one of the nations largest publically traded Insurance Agencies current trades at P/E multiple of 16 and 1.6 times sales based 2015 estimates; numbers that are not that far off of what you would expect to pay for a local accounting firm. 

When you think about it, the true value in owning a business or a portion of a business comes from the dividend and the expectation of future dividends.   If we lived in a world where the buying and selling of interests in a business wasn't facilitated by modern stock exchanges then the ONLY value a share of stock would have would be the dividend.   In other words, if you could not sell it then the only benefit you would get out of your stock would be the dividend.

It has been rightly said that the value of an asset is what it pays you.   Earnings and Sales are informative because they are indicative of what the business can pay in the form of a dividend and the dividend is what we want.   More importantly, we want the stream of dividends going forward.  

The real secret of investing in dividends is that we are not buying the dividend today; we are buying a rising stream of cash flow in the form of expected future dividends.   Ten years ago (in February of 2005)  we could have bought a share of Johnson and Johnson stock for around $64 a share.  The dividend at that time was $1.14 a share for a yield of 1.75%.  Over the next 10 years the price per share increased to around $105 per share (an increase of 64%).  Over that same time frame the dividend increased to $2.80 (an increase of 145%).  An investor putting $6400 into Johnson and Johnson stock in February 2005 would have received $4100 in capital appreciation and $2018.50 in total dividends. 

What is significant is that one third of the total return for this 10 year period came from dividends alone!  What is exciting is that based on her original purchase price, our hypothetical J and J investor is now earning a yearly dividend equal to 4.8% of her original investment.  (An investor purchasing the same stock 20 years ago would now be receiving an annual dividend equal to about 18% of their original purchase price.) 

And that brings us to the real value of a dividend portfolio.  When looking for dividend stocks do not become overly enamored by the current yield, instead look at the "future yield."  This years dividend has value, but the real value of our investment lies in  increasing income stream stretching off into the ever receding future.