Dividends and Yield on Cost

When a company makes a profit, they have 2 basic options at their disposal:  keep the profits for the company or reward shareholders with a dividend payment.

If a company keeps the profits for their business, the money can be used to pay down outstanding debt, used towards R&D to try to further increase future profits, add more money to their piggy bank, or potentially be wasted by inefficient operations, to name a few options.  This option is referred to as plowback  and gives us the plowback ratio:  Money not paid out as a dividend and retained for the business.

Plowback Ratio =(EPS – Dividends)/EPS

EPS = Earnings Per Share

Example: A company had annual EPS of $4.00.  For the year they paid out $1/share in dividends:

Plowback Ratio = (4 – 1)/4

Plowback Ratio = .75

This means 75% of earnings were retained by the company and plowed back into the business.  If a company does not pay a dividend, then the plowback ratio is 100%.

If you know the Dividend Payout Ratio, you can quickly figure the Plowback Ratio:

(1 – Dividend Payout Ration) = Plowback Ratio

Example: If a company pays out 25% of earnings in dividends, then

(1 – .25) = Plowback Ratio

.75 = Plowback Ratio

A company with a higher plowback ratio has more room to initiate or increase a dividend in the future.

(I hope you are noticing the simple math involved so far).

Paying your shareholders a dividend of a fractional amount of your profits is basically a nice way of the company saying “Hey, thanks for believing in us, here’s a quarterly/annual/special dividend payment.”  It’s a return of some profits to your shareholders, the investors in your business.  A reward for the risk taken.  A company that maintains it quarterly dividend is generally understood to show stability in its earnings in order to pay that dividend in the future.  When the company increases its dividend over time or offers a one time special dividend, this is normally understood as a company showing confidence in its future earnings growth ability.  Paying a dividend can also be regarded as keeping some of the cash away from management for misuse/waste of profits.  If the money is not there for them to use, in theory, they have to use their resources wiser, knowing a dividend payment is just around the corner.

Sounds simple, right.  Well, just the opposite can happen as well.  Dividends are not guaranteed and can be cut or suspended during rough times for a company.  For example, Transocean (RIG) recently suspended their dividend payments to shareholders because of declining profits due to the drop in oil prices (earlier this year they announced a cut to their dividend of $0.75 down to $0.15 per share per quarter).  Their profits have declined, forcing them to cut, then suspend, their dividend.  Your business needs cash to operate, paying out too high of a dividend means less cash on hand for daily operations.  Being a shareholder during these times can suck.  Your dividend income has declined, but also the stock price has declined.  Wall Street hates uncertainty.  Cutting your dividend is a sign of weakness, uncertainty of the future (I’ll get into some things to look at pertaining to dividends).

Real quick discussion on dividend payout ratio (how much of the companies earnings are being paid out to shareholders in the form of a cash dividend):

Dividend Payout Ratio = (Annual DPS/EPS)

DPS = Dividend  Per Share

Example: If a company pays out and annual dividend of $1/share and earned $4/share, then:

Dividend Payout Ratio = 1/4

Dividend Payout Ratio = .25

This means only 25% of a companies earnings were paid out to shareholders in dividends, 75% retained for the business.

It is possible for a company’s dividend payout ratio to exceed 100% of their earnings.  This is a red flag.  This means they are paying out more money than they are taking in.  A dividend cut may be looming around the corner if they don’t have money sitting in the piggy bank.  The lower the dividend payout ratio, the more headroom for future dividend increase or even one time special dividends*.  Think of it this way: A person spends all of the money they make in a month (living paycheck to paycheck) and doesn’t have any money saved up.  The first emergency that pops up, they are screwed and have to make concessions somewhere.

*(Special dividends are out of the ordinary one time payments that should not be expected.  The company may have had a killer year in profits, and just looking to give a nice little reward to shareholders.  CME Group is an example of a company with occasional special dividends.)*

One last bit of math for the time being.  Dividend yield is super simple to calculate (more division):

Dividend Yield = (Annual Dividend/Current Stock Price)

Example: A company pays an annual dividend of $1/share, current stock price is $50/share:

Dividend Yield = (1/50)

Dividend Yield = 0.02

This company has a current dividend yield of 2%.  The dividend yield is always changing, as the stock price changes.  As the stock price goes up, dividend remains the same, the dividend yield goes down.  Just the opposite property is true.  Dividend remains constant, share price drops, dividend yield goes up.  If we hold share price the same, and change the dividend amount (up or down) the dividend yield is also changing.

Now that we have laid down the foundation for dividends, we can start to get into the good stuff.  Why does all of this crap even matter?

I am usually asked a few, but always the same, questions about dividends and dividend growth investing:

  • Why do dividends matter to you?  You’re 35.  Dividend investing is for old people.
  • What kind of dividend companies do you invest in, what do you look for?
  • Why are you investing in those companies, company XYZ has a 10%+ dividend yield.  Much higher than your companies.
  • Do you really think you can live off of your dividend payments?
  • I learned in college that companies who pay a dividend, limit growth potential of their stock.  Aren’t you sacrificing appreciation of share price by investing in a dividend paying company?

Those questions will be addressed, but I also want to use, of course, a real world example from one of my holdings ExxonMobil (XOM) to ultimately show the importance of dividends over time to an investor and more specifically someone looking to retire (whether early or retirement in the traditional sense).  Also, this is a perfect time to get into the discussion of yield on cost, and I will use XOM as my example for simplicity of focusing on one company in this article.

WHY DIVIDENDS MATTER TO ME

I like, no, I freaking love dividends.  As a shareholder in a company, I can receive cash from an investment, while I wait for the share price to increase over time.  Basically, I’m getting paid to wait.  My goal is to live off of dividends and never have to touch my principal.  Receiving a quarterly dividend allows me to not have to sell my shares, and use the dividends to cover my living cost.  When you have enough dividend income coming in to cover your expenses, life is good.  It’s doesn’t happen over night, so start early.  You don’t have to be 65 to be a dividend investor.  While I am working, I am reinvesting my dividends that I receive back into those very companies.  This causes your dividends to buy more future dividends.  Pretty sick (I will have a future post going into more details on this).  When I retire, I will receive some of my dividends just in cash.

What about inflation?  More specifically, I am interested in dividend growth investments:  Companies who have a history of increasing their dividend slowly, but surely over time.  This is my inflation hedge for early retirement.  I like to be conservative on inflation estimates and use 4% as my long term expectation.  Lots of places will use a low 2%, but I believe that is an aggressively low expectation for the future.  At the turn of the century many places were using 3ish%.  I would rather overestimate than underestimate.  Worst case, I have extra disposable income because of it.  As an example of seeing dividend growth, check out my Dividends and Markets News tab.  It is primarily for reporting news on my holdings as they increase/decrease their dividends over time.  Altria (MO) is an example of dividend growth.  They increased their dividend 8.7% recently, and have historically had increases, as well.  Higher than my 4% assumed long term inflation rate.  I’m happy with that because of the excess difference.

Dividends are also an important component of total return for a portfolio and the financial markets as a whole.  You can search online and find examples.  The studies are everywhere, so no need to reinvent the wheel.

WHAT KIND OF COMPANIES, WHAT TO LOOK FOR

I keep it simple.  I like predictability in my investments.  Remember uncertainty can lead to chaos.  I want to know what I get and what I can expect to get.  If you look into “Dividend Aristocrats”, these are primarily the companies I’m interested for my the foundation of my dividend growth portfolio.  The “Dividend Aristocrats” have a history of 25+ years of increasing their dividends.  I sometimes venture off into trying to find the future potential dividend aristocrats.  Here is a site I like to use as a resource every once in a while about dividend history for a company, lots of good stuff at your finger tips.  I keep it simple, the US divided companies.  The company’s website will also have an investor relations page to look into historical information as well as sites like Yahoo Finance.

The things I look at in a dividend growth company are payout ratio (generally don’t want to high), earnings growth, cash flows, total cash, and debt.  Dividend history also plays role.  If a company has cut their dividend in the past when times were tough, they will probably do it again in the future.  A company who has ridden out a rough patch, controlled cost, and managed to increase their dividend is super sexy to me.  Apply this to a human being, would you invest money in someone who has debt through the wazoo, no cash to speak of, negative cash flows each month, and low to no future earnings growth potential?  You’re probably throwing you money away if you say yes.

WHY NOT INVEST IN THE HIGHEST DIVIDEND YIELDING STOCKS

At this time of writing, the dividend yield on the S&P 500 stands at 2.35%.  Basically for every $1000 invested in the S&P 500, you are getting $23.50 annually.  That is higher than normal yield for the index, because of the recent drops in the markets, but not a ridiculous yield.  I am normally asked told by others, you can get a higher dividend yield by investing in XYZ company.  For example, RIG, referenced above, earlier this year had an annual dividend of $3/share ($0.75 per share, per quarter) and when the stock was trading at $15/share, it’s yield would have been 20%.  I have no interest in ultra high yielding stocks.  It is not sustainable and will need to be cut at some point.  I prefer slow and steady on my dividend investing.  Currently there are several dividend aristocrats with a yield in the 3% neighborhood and have modest payout ratios.  So yes, you can create a portfolio with an ultra high yield, but what good is it, if your income will eventually drop from dividend cuts and respective drop in share price.

DO YOU REALLY THINK YOU CAN LIVE OFF YOUR DIVIDENDS

Yes… next question.  This is a combination of managing my cash outflows, building up income producing assets, growing those assets, and growing the income from those assets.  Based on a 3% yield for my portfolio, I would have dividend income of roughly $24,000 annually, starting out and expected to grow.  My expenses are way lower than that and leaves plenty of room for a margin of safety (look for a post on my expenses coming soon).  This didn’t happen overnight or by accident.  It was planned and expected.

I LEARNED IN COLLEGE THE DIFFERENCE BETWEEN VALUE AND GROWTH INVESTING

So did I, but I also live in the real world.  This discussion is usually introduced to students with the Modigliani and Miller Propositions.  You can read up on it, but the problem I have with the thinking are the assumptions: perfect world, no taxes, and rational investors to name a few.  I live in an imperfect world, pay taxes, and people behave irrationally all the time.  Also, in reality, there are tons of companies with shareholder friendly dividend policies that have destroyed the performance of the S&P 500 in the long run.  As mentioned above, dividends are a big component of total return.  I wouldn’t consider this sacrificing growth by investing in a boring dividend growth company (it’s a chart comparing Clorox vs the S&p 500).

REAL WORLD EXAMPLE

Now lets put all of the above information together and provide an example of a stock from my portfolio, ExxonMobil (XOM).

While finishing my master’s degree, I worked 2 jobs part time.  One job was retail that provided nice benefits like a stock purchase plan, a 401(k), and tuition reimbursement.  Obviously I would take advantage of those plans.  Eventually, after finishing school and working full time, I got to the point where I left the part time job at Sears.  I would rollover that 401(k) into an IRA and I purchased 2 stocks with the money, Johnson & Johnson (JNJ) and ExxonMobil (XOM).  Never adding additional funds to that account (opting for a Roth IRA going forward).  I had already become a buy and hold investor at this point of my life, learning from my previous mistakes.

October 30, 2003 is when I purchased 50 shares of XOM at $36.50 per share, total outlay of $1825.  I have been receiving dividends ever since.  I created the chart below, pulling dividend history for XOM.  Here is an Excel Spreadsheet that looks better XOM INFO, since the chart below looks like shit.

ExxonMobil Dividend Information (holding Period 10/30/2003 to Present)       
YearQtr Div Y/E% IncreaseAnnual AmountMy DRIPMy % Increase w DRIP
20150.730.0579710144927542.88
20140.690.0952380952380952.7
20130.630.105263157894742.46
20120.570.212765957446812.18
20110.470.0681818181818181.85
20100.440.0476190476190481.74
20090.420.051.66
20080.40.142857142857141.55
20070.350.093751.37
20060.320.103448275862071.28
20050.290.0740740740740741.14
20040.270.081.06
20030.250.086956521739130.98
0.09370193118505222.85
  • On my initial purchase of XOM stock, the original dividend yield was 2.73% (1/36.50)
  • Over my holding period of 12 years, the annual dividend income per share has risen from $0.98 to $2.88 annually for a 193% increase in your dividend income from this one holding alone
  • Total dividends received per share over that 12 year period would be $22.85 per share.  Meaning you have received 60.6% of your initial $36.50 per share purchase price back in the form of cash dividends
  • Current yield on XOM is currently 4.03% {(0.73*4)/(72.46)}
  • My yield on cost for my initial purchase of XOM is 8%.  By sitting on the stock and letting the dividends increase over time, it’s like I am getting an 8% dividend yield just by holding the stock.  This goes up over time as the dividend continues to increase
  • The average increase in the dividend during this 12 year period has been 9.37%.  Far surpassing the rate of inflation.  Fuck inflation protected bonds, right.  Dividend growth investing is an awesome hedge against inflation
  • Return on the investment of XOM is 98.52%, beating the S&P 500’s return of 81.50%
  • Total Return on the XOM position factoring in dividends is 161.1%.  Dividends made a positive 62.58% difference in the overall return.  Pretty freaking amazing.
  • Total dividends received on that original 50 shares is $1106.  Original purchase of XOM totaled $1825
  • This also has the ability to scale.  50, 500, 5000 shares, it’s all applicable no matter how you are starting out.  You just have to take the first step

**I am working on pulling DRIP info to update information for the spreadsheet.  I suspect the purchase of additional fractional shares will only serve to increase some of these returns a little.**

Hopefully the information provided shows the importance of dividends to investors over the long haul, in the real world.  XOM is just one of many dividend growth companies that show similar data with the ability to beat the major indices and provide nice growing income over time.

Dividend growth investing is one of my major pillars in trying to reach FI.  To achieve FI, you need to accumulate financial assets (building your liquid net worth), generate growing income from your financial assets (dividend growth), and limit liabilities/control cash outflows (stop buying useless crap).  2 of these take  time to build, you have the ability to immediately affect your spending.

A NOTE ON TAXATION OF DIVIDENDS IN A BROKERAGE ACCOUNT:  Ordinary dividends are taxed at your marginal tax rate.  If you meet specific holding periods for a common stock, then you get the benefit of a lower tax rate for qualified dividends.  For most normal people that tax rate is 15%.  For a dividend to be considered qualified you must have held those shares of stock unhedged for at least 61 days out of the 121-day period that began 60 days before the ex-dividend date.  In plain English, 60 days before ex-dividend date, 60 days after ex-dividend date.

US tax codes are written in a way to favor investors as opposed to the working average joe.  Long term capital gains rates and qualified dividends are ways that guys who make mind boggling money each year are able to keep their effective tax rates low.  They make most of their money from investments.  The average working joe makes his money from, well working.  The more this person makes, the more in taxes they will pay as they climb up the marginal tax brackets.  So, do what the wealthy do… invest.

Yield On Cost

I consider a concept of Yield on Cost to be important to a dividend growth investor.  Basically, it is calculated as:

Yield On Cost = Current Annual Dividend Income / Cost Basis of Stock

As a company grows its dividend over time, your yield on cost is going up.  If you have ever heard of the grandma that bought a stock decades ago, sat on it, and collected more in dividends each year than her initial purchase… it’s because of this stuff right here.  Over time it is possible to collect a nice chunk in dividend income each year compared to your purchase price of a stock.

Using XOM again as an example.  The original dividend yield when I purchased back in 2003 was at 2.73% (1/36.50).  Over time as the dividend has increased each year at an average rate of 9.37% to the current annual dividend of $2.92 (.73*4), my yield on cost of my original purchase in XOM is 8.00%.  Calculated as:

Yield on Cost =(0.73 x 4) / 36.50

Yield on Cost = 0.08

I am currently collecting 8% of my original purchase of the stock and this will increase over time as the dividend increases.  Again, I hate to sound like a broken record, but time is the most important thing, so start early.

The above discussion was to hopefully enlighten you on the importance of dividends as a part of one’s overall portfolio and investment strategy, and some of the factors to consider when looking into your own stocks.  The more time that passes, the more significant a role dividends will play for your investments.  So put time on your side and start early.  This post, to me, is about one of the most important topics in investing that does not get enough attention.  It is so important to me, that it has become the basis for me feeling confident in my ability to step into early retirement.

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