One of the most disturbing trends on Wall Street that I’ve noticed over the last 100 years is the movement away from an emphasis on dividends and a thorough examination of a stock’s dividend history.
There’s several reasons for this. One, a stereotype has been perpetrated that dividend stocks are only for risk averse investors, or those close to or in retirement.
Two, investors and speculators are so fixated on short term price appreciation and the use of charts as a benchmark that the effect of compound interest through reinvested dividends is hardly considered.
Of course, those of us from the “dividend growth” community are well aware of the power of reinvested dividends and are well versed in some of the facts that drive its success.
Most DGI investors know the sort of stats that show 44% of the total return of the S&P 500 over the last 80 years has been because of reinvested dividends, not strictly from positive movements in price. Or the impact of reinvested dividends on the total return from holding a single stocks through many years or decades.
But because the universe of dividend growth is quite small, and there are no “real authorities” on dividend growth (compared to say, Benjamin Graham or Warren Buffett on value investing or Jesse Livermore on trend trading), there subsequently aren’t many established financial metrics that focus on measuring the true success or failure of a company to reward its shareholders with dividends.
The common ones I can think of to evaluate the dividend history of a stock include: Current Yield, Recent Dividend Growth, Consecutive Years of Dividend Growth, and Yield on Cost (of course payout ratio is somewhere in the mix).
These are all fine metrics to evaluate how a stock’s dividend has historically rewarded shareholders– to a degree.
However, they miss a few key details that could have major impacts to a shareholder’s overall return from dividends and dividend reinvestment.
Additionally, these metrics don’t consider the other characteristics of a business’s financials that usually lead to management’s decision on how much to pay for a dividend– for example, analyzing the earnings growth potential from reinvesting into the business vs. giving the money back to shareholders.
Each of the widely accepted metrics for dividend history are missing one piece or another.
In this dividend mini-series I will introduce two dividend metrics of my own that hopefully paint a better picture of stocks that have provided investors with better overall return on their investment through returned cash vs. price appreciation and the uncertainty of that continuing.
We’ll examine each of the dividend history metrics mentioned above to show what they miss and how these two new metrics address that problem.
Finally, I’ll end with a plea. It’s up to us investors who want Wall Street to go back to a greater emphasis on paying dividends to make this change ourselves. As investors we can vote with our dollars. That’s the only way that companies and managements will hear us.
One single investor might feel powerless against being able to advocate for the change he or she wants to see. But many investors brought together can function as an activist investor to reverse the trend and inspire higher dividend yields, payouts, and overall potential return in the long run. I’ll share an idea that might make this possibility not too far-fetched.
Be sure to read each post of this dividend ratio series, they all depend on each other. Part 1 introduces the problems with today’s dividend ratios, Part 2 and 3 introduce two new metrics, and Part 4 combines the two ratios to identify the best managements both rewarding shareholders AND growing the business.
Dividend Ratios Pt. 1: Evaluating the Dividend History of a Stock
Dividend Ratios Pt. 2: How to Identify Sustainable Dividend Growth
Dividend Ratios Pt. 3: Measuring a Stock’s True Dividend Payout Ratio
Dividend Ratios Pt. 4: Combining Two New Metrics & Putting It All Together
Now let’s discuss some of the problems with the metrics that investors use when evaluating dividend stocks and what each of these metrics are missing.
Today’s Commonly Used Dividend History Ratios
The first metric is probably the most widely used when an investor starts to analyze whether to add a dividend stock to his portfolio.
–Dividend Yield: Dividend Paid / Share Price
This metric obviously tells you how much yield to expect on your investment if you were to buy this stock today. It can have a great effect on your overall return in the long run, as higher initial yields lead to greater sums as it compounds through the years.
However, this metric doesn’t tell us anything about a stock’s history with its dividend payment. A stock could have a great yield simply because it’s been beaten down and is out of favor in the market. It does nothing to tell us about what kind of dividend growth to reasonably expect in the future. So we must do better.
–Recent Dividend Growth
This metric can address the problem above, somewhat. Like investors can do for earnings growth, we can look at the history of dividend growth and extrapolate it out into the future to consider a reasonable expectation of future growth.
Of course, past performance doesn’t guarantee future performance, but understand that this is a problem with pretty much every metric used on Wall Street anyways.
We can minimize the risk this creates through the use of multiple metrics, but we can never completely eliminate it. Uncertainty is part of the game, it’s what creates returns.
Instead, the problem I see with the history of dividend growth is that it doesn’t take into account previous special dividends and whether the reallocation of capital was used prudently into either paying dividends or reinvesting in the business. This omission summarizes the biggest problem with the ways currently used to evaluate a stock’s dividend history– and this is a big problem in my opinion.
–Consecutive Years of Dividend Growth
This metric falls victim to the same shortcomings as the historic dividend growth metric as well. The big one here relates to the 2nd part of our problem, the reinvestment vs. dividend payout.
Smart management might understand the attention surrounding this metric and thus be too conservative with their payments, in order to increase the likelihood that they’ll have the ability to continue increases later on.
For example, if reinvestment in the business returns creates a subpar amount of future earnings– it’s still some sort of improvement for the future.
A company might only increase the dividend enough to stay consistent with its ongoing track record of dividend increases, and waste the rest inefficiently with the purchase of low returning assets. In essence, no harm no foul– and investors demanding dividend appreciation are appeased.
–Yield on Cost
This dividend metric gets the closest to achieving what we want to see from a dividend history metric, one that more accurately represents a potential’s total return potential over the long term.
A metric such as this is subjective, it depends on when an investor personally bought the stock. Dividend investors may use Yield on Cost to evaluate how a stock is performing for them over the years. And that’s very fair.
Say an investor bought a $100 stock paying a $5 dividend. Say that 3 years later, the dividend payment for that stock is now $6.65. The yield on cost for the investor is now 6.65%, even if the original yield at purchase was 5%, because the stock was bought at $100.
Though a great measure for looking at the income streams an investor is receiving for his or her long term investment, it again doesn’t take into consideration any sort of special dividends. It doesn’t evaluate if management has been giving shareholders their fair share.
So, we must make a metric (or two) of our own. And hopefully make it simple so that can become widely accepted and used.
If investors then vote with their dollars, rewarding the businesses and managements who are able to achieve high levels of performance based on better metrics like these, then it will only make sense for managements to focus on it.
Introducing Two New Dividend Ratios
Here I will present two new ratios that improve on the ones already commonly used by many investors to make purchase decisions and evaluations on a stock’s dividend history.
Click on each link to get started. Remember that each of these metrics aren’t standalone, they tell one side of the story. It’s by combining both that you’ll identify the managements that are truly allocating capital the best.