Simply put, investing is all about buying a series of cash flows. More comprehensively, the value of a stock should equate to the present value of all future cash flows to equity-holders using a discount rate that accounts for time and risk.
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Typically, an investor would estimate the future cash flows and work backwards to determine an appropriate price for the stock. If the stock is trading below the estimated value, the investor would buy with the expectation the price would eventually reach its fair value. Longer term investors might continue to hold a stock – even if it’s trading at fair value – because they expect to receive a return on their investment.
The problem with the traditional way of evaluating a stock is that price fluctuations can take investors on an emotional roller coaster, leading them to make bad decisions.
Below I present an alternative, somewhat backwards – but otherwise appealing – way to look at a stock by solely looking at the dividends received.
This way to look at a stock is as if you were buying an annuity (from an insurance company) that pays growing cash distributions. While you still own the original capital (and any capital appreciation), which you wouldn’t with an insurance annuity, the key to this analytical approach is to assume you don’t. Essentially, you trade a lump sum today for an infinitely continuous and growing stream of dividends.
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Becoming a dividend collector
I think this psychological ploy can help some investors avoid over-trading their accounts by ignoring price fluctuations, instead focusing on dividend income generated by the portfolio. Dividend streams tend to be more stable than stock prices, resulting in less emotional distress. This is because even during bear markets, many companies will continue to pay and even grow their dividends. The dividend collector is far less emotionally sensitive to market movements than the traditional portfolio manager. The dividend collector is also more likely to remain invested for the long term, thus creating greater wealth than someone who trades on emotion.
The investing purists will say that total returns (price fluctuations + dividend income) is what matters. I agree. In the end, you’ll be collecting and reinvesting dividends plus (hopefully) growing your initial investment over time. That’s the beauty though. By ignoring your original capital investment and focusing solely on the dividend stream, any growth in capital becomes a fabulous added bonus at the end of your investment horizon.
Today’s small dividend becomes tomorrow’s big dividend
For simplicity’s sake, assume an initial investment of $100 into a dividend paying stock. Assume the annual dividend on that stock is $2.50, but grows at 6% annually.
(Note: In reality you wouldn’t invest in just one stock. To reduce risk, you’d diversify across a number of dividend paying stocks and research the quality of each of those dividends.)
The chart below illustrates how that annual dividend would rise each year over 20 years.
As the $2.50 dividend grows to $8.02 over 20 years, an initial 2.5% dividend yield today becomes an 8.02% dividend yield based on your original investment.
An investment that pays for itself
Giving up some money today in exchange for an escalating cash payment sounds appealing. But you also have to consider how that money accumulates over that 20 years. Over that period you’ve collected almost $100 worth of dividends ($99.98 to be precise). So you’ve recouped your original investment – presumably to put to work in another asset – and you’re continuing to generate 8.02% on your original investment.
Now take that experience and scale it up to a $1,000,000 fully diversified portfolio of dividend stocks. Under the same assumption, that portfolio has generated almost another million over 20 years plus eventually spits out an income of $80,200 that continues to grow. Realistically though, you’ve also reinvested the accumulated dividends (thus generating additional dividend income) plus your portfolio has likely grown (the added bonus I mentioned above).
Again, I want to stress this isn’t necessarily an academically complete way of looking at an investment. However, I find that focusing on the continuous and growing stream of cash flows generated by an investment helps some people stick to a long-term plan. Consequently, they are better equipped to grow wealth over the long term and avoid emotional sell/buy decisions along the way.