When evaluating a stock, many people pay a lot of attention to those that pay high dividends. This makes perfect sense -- dividends can provide a stream of income for retirees, or could grow and compound over time through dividend reinvestment. However, don't ignore a stock's total return, which means much more to you over the long run.
What is total return and how do you calculate it?
Total return is a measurement of the overall rate of return of an investment, including dividends, interest payments, capital gains, and any other distributions. For stocks, this generally means just capital gains and dividends, and it assumes reinvestment of those dividends.
For a simplified example, let's say you buy 100 shares of a certain stock at $20 per share, so your investment's initial value is $2,000. We'll say the stock pays a 5% dividend, which you reinvest, buying five more shares. After one year, the share price rises from $20 to $22.
Based on the share price alone, you have a 10% gain. However, since you now own 105 shares after reinvesting your dividends, your investment is worth $2,310, or 15.5% more than you paid for it. That's your total return.
You can use a fairly simple formula to calculate your total return over any given period of time. Simply take your total investment gains (in our example, $310), and then divide it by the original value of the investment ($2,000). Multiply by 100 to convert the answer into a percentage, and that's your total return.
Why it's so important
Total return is crucial because some of the best dividend stocks actually have relatively small growth potential, and therefore produce little in the way of capital (share price) gains.
I've written several times about the Dividend Aristocrats -- the group of stocks that have increased their dividends for at least 25 consecutive years. As far as dividend investing goes, these stocks produce some of the safest and most predictable income streams in the market. However, these companies' growth potential can vary tremendously, along with their total return.
Consider AT&T (NYSE: T), which is one of the highest-paying Dividend Aristocrats, with a 5.42% annual yield as of this writing. However, AT&T is not a high-growth stock, with revenue rising at what I would call a "slow and steady" pace for many years now. It does produce a high amount of reliable, growing income, which makes it a great choice for retirees, but its relatively low total return potential means it might not be the best choice to grow and compound over time. (Full disclosure: I own shares of AT&T as a "safety" play in my own portfolio)
Here are some of the most popular Dividend Aristocrats, listed from highest dividend yield to lowest. Keep in mind that all of these stocks have increased their payout for more than 25 years in a row. Notice that some of the lower-dividend stocks actually turn out to be the long-term winners.
|Company||Symbol||Dividend Yield||20-year total return (%)||Annualized average total return||Growth of $10,000 invested 20 years ago|
|Procter & Gamble||PG||3.32%||621%||9.9%||$72,100|
|Johnson & Johnson||JNJ||2.96%||886%||11.4%||$98,630|
Of course, these stocks' past performance doesn't guarantee their future results. And, obviously, all low-dividend stocks won't outperform all high-dividend stocks. However, many investors love Dividend Aristocrats because they are the most predictable, and therefore the most likely to continue of the same trajectory.
When considering any stock you intend to buy for the long haul, it's important to evaluate the big picture, and not just any single return metric such as dividend yield. Total return is the best way to measure how much wealth a stock creates in your portfolio over time, and is infinitely more important to long-term investors than dividend yield.
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Matthew Frankel owns shares of AT&T.; The Motley Fool recommends Coca-Cola, Johnson & Johnson, and Procter & Gamble. The Motley Fool owns shares of Johnson & Johnson and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. 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.