The Basics of Dividends

This article is part of our Better Investor series, in which The Motley Fool goes back to basics to help you improve your returns and be more successful with your investing.

Stop me if you've heard this one. Stocks are stuck in a lost decade. The Dow Jones currently trades at around 11,000. In 2000, it was about the same. A full decade of zero returns. It's a tough statistic to swallow.

But it's equally flawed. Add in dividends, and the Dow has actually increased some 43% over the past 10 years.

Every investor's love for investing can be, or should be, improved by appreciating the power of this chart:

Sources: Yale University, author's calculations.

Albert Einstein called compound interest "the most powerful force in the universe." This chart illustrates why. Dividend investing is powerful stuff that can lead to phenomenal long-term wealth generation.

When a business earns a profit, it can do one of three things: keep the cash in the company to expand operations or repair its balance sheet, repurchase shares, or pay a dividend.

In previous decades, dividends reigned king among those three choices. From 1920 to 1950, the dividend payout ratio (dividends as a percentage of net income) was 72%.

But then began a great shift. Corporate executives got the idea that they could build shareholder wealth more effectively by using retained earnings to build new factories, finance new products, acquire competitors, or repurchase shares. From 1950 to 2010, the average dividend payout ratio fell to 51%. Today, it's less than 30%.  

By and large, this has not been a fortunate trend.

Some companies should have a low dividend payout ratio, if they pay a dividend at all. In the early days of Google (Nasdaq: GOOG  ) , for example, cash was almost certainly better off funding expansion. Berkshire Hathaway (NYSE: BRK-B  ) has never paid a dividend, but it shouldn't, because Warren Buffett can reinvest money far better than you or I can.

But those are the exceptions. Multiple studies around the world confirm that a lower dividend payout ratio does not lead to higher future earnings. In fact, there's a wealth of evidence showing the opposite: Future earnings growth is fastest when the payout ratio is the highest.

How can that be? Corporate executives, it seems, are poor investors. Cash not paid out as dividends is often squandered on overpriced acquisitions or used to repurchase shares at ill-timed and overvalued prices. Dividends are typically the greatest way management can build wealth for their shareholders.

Consider one amazing statistic: In the 50 years ended in 2003, the single best investment to own was not a tech company like Microsoft. It wasn't an explosive newcomer like Wal-Mart. It was cigarette giant Altria Group (NYSE: MO  ) .

Altria invented nothing new during this period, and, remarkably, smoking rates have been declining for decades. What it did have going for it is an unwavering commitment to its dividend. That dividend, reinvested and compounded over time, pushed total returns to amazing heights. Ditto for other companies that emphasize dividends:

Company

Share Appreciation Since 1970

Total Return Since 1970 With Dividends Reinvested

Altria 6,600% 162,800%
General Mills (NYSE: GIS  ) 4,300% 18,700%
Coca-Cola (NYSE: KO  ) 4,600% 14,200%
Southern Company (NYSE: SO  ) 250% 11,800%
Pfizer (NYSE: PFE  ) 2,600% 8,500%

Source: Capital IQ, a division of Standard & Poor's.

Dividend investing is not without risk, of course. Big banks like Citigroup and Bank of America used to pay enormous dividends. Both stocks fell more than 90% as their businesses crumbled. Some note that dividends can provide downside protection during market slumps as investors chase yield, but this is only true as long as the dividend isn't cut, which they often are. High dividends are no substitute for good businesses.

For those interested in dividend investing, keep three things in mind:

1. Track records are important.
Ben Graham, Buffett's early mentor, advised looking for companies with at least a 20-year track record of paying dividends. These are easier to find than you might think. Standard & Poor's keeps an index of what it calls "dividend aristocrats," or companies that have not only paid but increased dividend payments every year for at least a quarter-century. There's no guarantee these businesses will outperform, but it's a great starting point for finding ideas. For more passive investors, funds like the Vanguard Dividend Appreciation ETF effectively track a similar index of high-quality dividend stocks.

2. A high yield can be a warning sign.
A stock with an abnormally high dividend yield can be a sign that investors think its dividend payout is in danger of being cut. A good way to gauge whether a company can maintain its dividend is by checking the ratio of dividends to free cash flow. There are no firm rules, but in general you want dividends to make up no more than 60%-70% of free cash flow. Any higher, and that payout is at a higher risk of being cut.

3. Reinvest!
Some investors use dividends to pay bills or even live off them during retirement. That's great! For all others, a commitment to reinvesting dividend proceeds back into the company is key to generating the greatest long-term returns. Most companies and brokerages allow you to reinvest dividends simply through what's called a dividend reinvestment plan, or DRIP. Once your DRIP is set up, you'll receive dividends automatically in the form of additional shares of that company's stock. Rinse. Repeat. Enjoy.

Stay tuned throughout our Better Investor series and get the advice you need to succeed with your investments. Click back to the series intro for links to the entire series.

Fool contributor Morgan Housel owns Altria, Southern Company, Microsoft, the Dividend Appreciation ETF, and Berkshire Hathaway. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Coca-Cola, Citigroup, Bank of America, Altria Group, Google, and Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Pfizer, Berkshire Hathaway, Coca-Cola, Google, and Southern. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (10) | Recommend This Article (46)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 07, 2011, at 3:39 PM, TimothyVR wrote:

    Good article. I appreciate those tables that show share appreciation and the compounding of reinvested dividends. I won't invest in Altria because of the effects of cigarette smoking, but Coke and JNJ will have to do.

    I am skeptical at this point about Berkshire. It is worse less now than when I paid for it at the end of 2009. Dividend payments would at least ease some of that loss.

  • Report this Comment On September 07, 2011, at 3:46 PM, TimothyVR wrote:

    That should be 'worth less' not 'worse less'....

  • Report this Comment On September 07, 2011, at 5:51 PM, shoemaker17 wrote:

    if Buffett is such a great investor, how come he never bought any altria? yeah I just blew all your minds right there...

  • Report this Comment On September 07, 2011, at 5:53 PM, TMFHousel wrote:

    ^ I believe he's mentioned before that he's morally opposed to the company.

  • Report this Comment On September 07, 2011, at 6:47 PM, shoemaker17 wrote:

    why would he be opposed? the world is overpopulated. If anything, cigarettes are the one decent thing human beings created. oh, and they are delicious.

  • Report this Comment On September 07, 2011, at 8:16 PM, Dmama wrote:

    Thanks Morgan,

    Just what I needed as a new investor! I'm getting some good advice from SA service but am trying to learn more about how dividends work. Seems like it is a great long term wealth builder.

    I like that you write about stocks you actually own, as well.

    Appreciate the work you guys do here!!

    Dmama

  • Report this Comment On September 08, 2011, at 5:08 AM, mustang28027 wrote:

    Morally opposed to Altria? One could argue that drinking huge amounts of carbonated sugar water( Coke) has a negative impact on overall health in the form of being overweight and the problems that can occur from that, such as diabetees, heart disease, etc. Buffett puts on a good show as being grandfatherly and moral, but at heart it's the money that counts, it's the game.

  • Report this Comment On September 08, 2011, at 11:09 AM, Retrojbug wrote:

    Morgan,

    You might want to check out this link regarding your Einstein "quote":

    http://www.snopes.com/quotes/einstein/interest.asp

    I have heard this before and thought it to be suspicious. Just wanted you to be informed.

  • Report this Comment On September 08, 2011, at 4:13 PM, hbofbyu wrote:

    Without a doubt the most powerful force in the universe is intelligence.

    The capacity to collect, share, reorganize and act on information is unlike anything else in this universe. Intelligent beings can build tools, adapt to and radically change their environment, create complex systems and act with reasoned intention. Intelligent beings can plan, solve problems, think abstractly, comprehend ideas, use language and learn.

    #2. Love

    #3 Black Holes

  • Report this Comment On September 10, 2011, at 7:30 PM, ReddTiger wrote:

    Another option for reinvesting dividends, is to invest in dividend oriented etf's. Especially since some brokerages now offer commision free investing in etf's. This will allow you to diversify your investments as they grow.

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