What's the most important thing to consider when choosing a dividend stock? If you think it's the current dividend yield, you're wrong. While a high yield is definitely nice to have, especially if you rely on your stocks for income, the most important thing to look for is a stock's potential for high total returns, which could mean millions of dollars for your portfolio over time.
What is total return?
A high dividend yield is nice, but doesn't necessarily make a dividend stock a great investment. It's far better to have a consistently growing dividend as well as potential for the stock itself to appreciate over time.
The combination of dividends and price appreciation is known as total return. For example, if a stock's price rises by 5% this year, and it pays a 3% dividend, it's total return would be 8%. As we'll see shortly, this is how dividend investors get rich over time.
The power of compounding
There are two main types of interest, or returns, in investing: simple and compound. Simple interest refers to the same rate of return each year. Bonds are an example of an investment that pays a simple rate of return. If a $1,000 bond has a 6% coupon interest rate, you'll get $60 per year for the life of the bond -- no more, no less.
On the other hand, compound interest can be a dividend investor's best friend. In a nutshell, compound interest means interest is paid on the principal as well as the interest already accumulated.
For example, let's say you own $10,000 of a stock that pays a 5% dividend. By choosing to reinvest your dividends in additional shares of the same stock, you can take advantage of compounding. The first year, the stock will pay you $500 in dividends, which you use to purchase additional shares. Now your investment is worth $10,500, and your next 5% dividend will be worth $525, bringing your investment's value to $11,025.
The point is that every year, your dividend will get bigger. In fact, after 20 years, your dividend payment would grow to $1,263 -- and that assumes the dividend itself doesn't grow. Once that variable and an increasing share price are factored in, you might be surprised at what can happen.
Compound total returns can make you rich
To illustrate the amazing power of compound total returns, I'll use one of my favorite dividend stocks as an example -- healthcare real estate investment trust Welltower (NYSE:HCN).
Welltower has been a publicly traded company for approximately 45 years, and during that time, the company has increased its dividend consistently at an average annual rate of 5.7% thanks to ever-increasing income from its portfolio of properties. Also, because real estate tends to appreciate in value over time, the share price has risen substantially as well. In fact, between dividends and the share price, Welltower has produced an average 15.6% total return since its inception.
Here's where it gets fun. Let's say an investor bought $10,000 of Welltower stock 45 years ago and reinvested all of the dividends she received over the years. How much would her investment be worth today? $500,000? A million dollars, maybe? Actually, this investment would have ballooned to $6.8 million thanks to compounding. Imagine if this investor didn't stop with the initial $10,000 investment and had added to it over time -- we could be talking about a return well into the eight-figure range.
Now, keep in mind that if you had actually made this investment, the performance wouldn't have been nearly as steady as the line in this chart. Like any other stock, Welltower has experienced its ups and downs over the years. However, as long-term investors, we're far less interested in a stock's performance in any short time period than we are in its potential to deliver market-beating performance over time.
As a final point, dividend reinvestment doesn't need to cost you a dime. Most stocks can be enrolled in a dividend reinvestment plan (DRIP) either through your brokerage or directly through the company. When enrolled, any dividends you receive will be used to buy additional shares, even if the purchase results in fractional shares. If you get a $60 dividend payment and the stock is trading for $40, you'll get 1.5 shares added to your account -- and without any commission whatsoever. For these reasons, it's important to do this with every dividend stock you own.
Invest early and often, and let your dividends ride
The main takeaway is that time is a dividend investor's greatest ally. Since the power of compound returns increases over longer periods of time, now is the most critical time to get started. So, pick your high-quality dividend stocks, be sure to enroll them in a DRIP through your brokerage, and start investing as soon as you can. If you do that, you'll see firsthand just how powerful those seemingly small dividends can be.
Matthew Frankel owns shares of Welltower. The Motley Fool recommends Welltower. 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.