Dividends: Cash Back Off Your Purchase Price

One of the most rewarding experiences of being an investor is receiving dividends from the businesses you invest in. Most people have heard the term “dividends” and understand what they are, but for clarification purposes, a dividend is a return of earnings/profits back to shareholders, typically in the form of cash.  This cash is yours and you keep it regardless of the future performance of the stock.  The dividends received can be used to buy your morning Starbuck’s, gas, food, or you can reinvest that cash back into the company and buy more shares.  In fact, a lot of companies and brokerage firms make reinvestment of dividends very simple by allowing for an automatic reinvestment of dividends.  This is a great benefit because there is no transaction fee and it also allows for the buying of partial shares, instead of a round number as typically required.

For a young investor that is not in need of the income from dividends to pay bills, reinvesting the dividends is a great strategy and can drastically enhance long term returns. The constant accumulation of more shares from dividend reinvestment may start out very slow and boring, but in the long run, they become very meaningful.  When the board of directors declare a dividend payment to shareholders, it is typically stated numerically on a per share basis.  For example, if a dividend of $1.50 per share is declared and you own 100 shares, you will receive $150.00.  If you choose to reinvest those dividends, and the stock is trading at $50 per share, you will now own 103 shares because that $150 bought you three more shares of ownership.  The next time a dividend is declared, which for most companies is on a quarterly basis, you will receive more in dividends than before because you own more shares, assuming the dividend payment amount is not decreased.  If you continue this cycle, you can see how over a long period of time, dividend reinvestment can make a considerable difference.

One of the most interesting concepts I learned about dividend payments came from this article by private investor Joshua Kennon. In this article, Kennon explains that dividends should be looked upon as a rebate, or cash back from your original purchase price.  To make things simple, let’s assume you purchase stock of a company at $50 per share, and later on in the year the company declares a dividend of $2 per share.  Let’s also assume that you hold onto your investment for 10 years, and each year the company kept their dividend payment at $2.  As an investor, over that 10 year holding period you received over $20 per share in dividend payments for your ownership in this company.  Now the question can be asked, “what was your actual cost of ownership in the company?”  Many would say the original $50 per share you paid in the beginning.  However, when you view the dividends as rebates or cash back off your purchase price, it’s easy to see that your actual cost of ownership for that company was only $30 per share.  This is important because a typical stock chart will never show you this kind of data and the real returns of an investor who bought and held over a 10 year period.  Typically, a stock chart will simply show the historical prices of the stock compared to what the price is now.  In our example, if someone were to look at a stock chart and see the stock you bought for $50 per share 10 years ago that is now trading at $55 per share, most people would think this investment only returned $5 per share gain over a 10 yr period, when in reality it returned over $20 per share in dividends and $5 in unrealized capital gains.  That is a dramatic difference in return on investment when compared.

It must be understood that dividends are not guaranteed. To sustain dividend payments, a company must be consistently making money, or else they will have to finance or dilute ownership by issuing more shares to generate cash to fund the dividend payments, which is not a sustaining business model.  With that said, there are numerous companies out there that have consistently increased their dividends for decades and routinely generate profits year in and year out.  They are typically boring companies that have products right under everyone’s nose on a daily basis, but are ignored by Wall Street and the media talk show hosts, and therefore ignored by investors.  I love to find these companies and load up on shares and then do nothing but remain patient. Each year, dividends are paid and reduce my cost basis by providing “cash back” off my initial purchase price.  In our previous example, an investor that bought the shares at $50 per share and received over $20 worth of dividends over 10 years has a net cost basis of $30 per share.  That means that the share price of that company could have dropped to $30 per share, which is a 40% decrease, and yet an investor is still breaking even on their investment if they were to liquidate and sell that day.  Very few financial advisors or stock brokers talk about that fact.  It doesn’t pay to talk about that. Most financial advisor and stock brokers/brokerage firms profit off of activity and transactions.  Instead of viewing investing as an auction and gambling casino, think like a business owner and buy good companies at a fair price, especially companies that consistently reward their investors with dividends that they have consistently increased each year for decades.  Much like my previous “What am I buying?”, these companies are out there right in front of you every day when you buy gas, groceries, personal care products, alcohol, home goods, etc.  Take the time to think about the products and services that you and others consistently buying and look to see who owns those brands.  Research those companies and take a look at their dividend payment history.  Have they consistently increased their dividends year over year?  That’s not a sole determining factor in making an investment, but it’s one of many qualities to look for.