With all things being equal, dividend paying common stocks provide their shareholders a return bonus, or what some might like to call a kicker, over an equivalent common stock that pays no dividend. Many investors do not see it this way, as they tend to think of the dividend providing them their return. However, the stock market capitalizes earnings whether a company pays a dividend or not. Moreover, we contend that the market will value a given company’s earnings based on their past and future prospects for growth, again, regardless of whether a dividend is paid or not.
To clarify our point further, an investment in a common stock typically offers their shareholders two components of return. The first component is the capital appreciation component or the increase (or decrease) in the stock’s value over time. The second component is the dividend, or lack thereof, that the company pays to shareholders in cash, typically once a quarter. The two added together equal the shareholders’ total return. On the one side, we have the capital growth component and on the other side the income component.
Now, here is the primary point behind this article. If you examine two companies with equivalent rates of earnings growth, where one pays a dividend and the other does not, the dividend payer will provide their shareholders a higher total return. In other words, we’re suggesting that both stocks will provide equivalent capital appreciation when measured over a time period when the market is behaving rationally. We would define this as a time period when both stocks were being priced at fair value in the beginning and in the end. Consequently, the stock that pays a dividend to its shareholders is providing them a return bonus or kicker.
What we are about to say next may come as heresy to the devout dividend growth investor. Nevertheless, the facts speak for themselves and we ask that they try to look at the total picture with an open mind, and eyes. In either case, dividend paying or not, the bulk, or majority, of total return will be provided by the capital appreciation component. This is why we are saying that dividends are a kicker or bonus return. In other words, capital appreciation is the cake and dividends (if any) are the icing.
As a point of further clarification, this principle applies to the true dividend growth stock. We would define a true dividend growth stock as a company that has historically grown earnings at an above-average growth rate, and is expected to continue growing earnings at an above-average rate in the future. To clarify even further, low growth dividend paying stocks like utilities will often provide their shareholders the bulk of their returns through dividends. This is due to the low growth nature of their earnings which typically leads to subpar capital appreciation.
(If you would like to test this last statement regarding utilities, follow this link to Addendum To – Investing in Eastern Utility Stocks – Do Today’s Valuations Make Sense, Part 4)
A Picture Is Worth 1000 Words
To illustrate the validity of the thesis behind this article, we are going to once again rely on the F.A.S.T. Graphs™earnings, price (and dividends) correlated research tool. This powerful “tool to think with” was designed to graphically, and therefore, instantaneously portray the important principles underlying the total return that shareholders can expect from a given common stock. More importantly, they were designed so that each of the two components of return, capital appreciation and dividend income, could be visually exposed independently and therefore, returns easily and quickly calculated.
The Total Return Component
The total return component is driven by the market pricing a company according to its earnings achievements. Therefore, the orange earnings justified valuation line on each of the following graphs represents what we call the True Worth™ or what others might call the intrinsic value of each sample company, again, based on the market capitalizing its total earnings. Simply stated, when the black monthly closing price line touches the orange earnings line, fair value is present.
Focusing on this earnings and price relationship will provide an instantaneous perspective of capital appreciation as long as fair value is present in the beginning and the end. All that the reader has to do is look immediately to the right of each graph to find the company’s earnings growth rate listed and use it to easily estimate returns.
Consequently, without any mathematical computation, the reader should understand that the capital appreciation component will precisely equal, or at least closely correlate, to the company’s earnings growth. Therefore, when price starts on the orange line and is on the orange line at the end, whatever the earnings growth rate is, the capital appreciation will also be (within minor valuation adjustments).
In order to demonstrate this as clearly as possible, we had to carefully pick historical time frames where earnings and price were correlated (the price touching the orange line) both at the beginning and at the end. Although we could not do this with absolute precision, as you will soon see we were able to accomplish it within reasonable margins of error.
In other words, the price and earnings relationships we are showing are not perfect matches, but very close. However, in order to carry out this objective with the examples chosen, we had to draw some of our charts where we ended them through calendar year-end 2011 because valuation was in alignment at that time (thereby eliminating any 2012 data points). This was done in order to visually articulate the principle that we are hypothesizing.
The Dividend Income Component
Interestingly enough, the dividend income component is also driven by and is a function of the company’s earnings achievements. Even though dividends are paid out of earnings, we intend to demonstrate that the market eventually capitalizes the full measure of the company’s earnings even though a portion has been paid out. Therefore, the dividend component becomes, as our thesis indicates, an extra or bonus piece of return.
In order to depict this as vividly as possible, we chose to illustrate the full measure of each company’s earnings (the green shaded area with the orange line on top) and then illustrate the dividend component separately. Therefore, we calculate the dividends paid out of earnings (light blue shaded area) and show them as additional return by stacking them on top of the green shaded earnings area on the graph (Note: The orange line represents the fair value of the company’s earnings, while the green shaded area represents the total earnings). We believe this serves as a constant reminder that even though dividends come out of earnings, the capital appreciation component of the dividend paying stock is not reduced or diminished by the dividend.
A quick word about ex-dividend dates are in order. Although it is true that a company’s stock price will fall at precisely the level of its declared dividend, this is only relevant for that brief moment in time. In any other time during the quarter, and usually almost immediately following the ex-dividend date, the company’s stock price will be once