Better Total Returns

OK, class, the days are getting shorter, a sprinkling of leaves has begun changing colors, and the baseball pennant races are starting to heat up (with my Chicago Cubs all but mathematically eliminated from the playoffs). That can only mean one thing -- school's back in session. As such, now is the perfect time for a two-question Motley Fool pop quiz. As always, this will be an open-book test, so feel free to peruse the rest of the site to track down the correct answers.

Question No. 1: "Total Return" can best be described as ...

A. The difference in the value of a stock between when it was purchased and when it was sold, less any brokerage commissions.
B. The actual rate of return on an investment, including both capital appreciation and dividend distributions, usually expressed as a percentage.
C. The after-tax profit a portfolio has earned over a given period.
D. The 1990 hit science fiction thriller starring Arnold Schwarzenegger as a seemingly ordinary working man who must travel to Mars to uncover his true identity.

Question No. 2: Since 1926, the S&P 500 has delivered an annualized total return of 10.5%. What percentage of that was contributed by dividends?

A. 2%
B. 41%
C. 3.1415927%
D. 24%

For those of you who answer "B" to every question in the hope of getting at least 25% correct -- you know who you are -- you got lucky this time. Congratulations, though, to those that actually have a firm grasp on the concept of total return and the integral role that dividends play in the equation. While seemingly simple, it has managed to stump quite a few novice investors.

Don't judge a book by its cover
Many investors mistakenly assume that figuring the gain on an investment is simply a matter of subtracting the purchase price from the sale price -- buy at $10, sell at $11, and pocket $1 (for a 10% profit). If that was the case, though, then money market accounts -- which typically maintain a stable $1.00 NAV at all times -- would never show a profit. When a stock or mutual fund pays a distribution, its share price is adjusted accordingly, so the true profit on an investment cannot be determined so easily. To be sure, capital appreciation goes a long way in reflecting how profitable an investment will be -- but it is only a component of the bigger picture.

Obviously, the importance of dividends should not be discounted. Without those payments -- to refer back to question No. 2 -- stocks have only returned a mere 6.5% annually over the past 80 years. Before we tackle the subject of total return, read my Foolish colleague Tim Beyers' instructive lesson on putting dividends to work. Go ahead and study it now -- I'll be grading the Scantrons while you're gone.

Regular Fool readers have likely noticed that as a group we are generally big fans of the power of dividends, particularly now that new legislation has mandated that Uncle Sam treat qualified dividends in the same tax-advantaged manner as capital gains. And what's not to like? In a world where corporate earnings can easily be manipulated, distorted, or restated, dividend checks represent cash in the bank. To drive home that point, let's take a look at the dividends offered by Bank of America (NYSE:BAC):

As the chart shows, Bank of America is currently paying out a total annual dividend of $2.00 per share, which comes in the form of regular $0.50 quarterly distributions. In other words, an investor who owns 10 shares of the company could reasonably expect to receive $20 per year in dividend payments. While this trifling amount may seem inconsequential -- about enough to buy concessions at the movies -- the magic of reinvesting can speed up the growth process. After all, that money can be used to purchase additional shares, which in turn will throw off a larger total dividend payment, which will then buy even more shares ... and so forth.

OK, so we know that Bank of America shareholders are set to receive a $2 per-share payment for doing nothing more than holding the stock. What we don't know is just how generous that dividend is. By comparison, it seems paltry next to the $7.40 that media giant Washington Post (NYSE:WPO) shells out every year. Therefore, in order to level the playing field, we must divide the annual payment by the current price of the shares. That simple calculation will tell us each stock's yield -- which is how a firm's dividend is typically expressed.

Bank of America
$2.00 / $43.68 -- 4.57% yield

Washington Post
$7.40 / $820.00 -- 0.90% yield

Now we can make an apples-to-apples comparison. While the Post's payout looks juicy on the surface, it takes a whopping $820 -- the price of a single share -- to be entitled to receive it. When placing both payouts in the proper context, the Post's sub-1% yield looks rather pedestrian beside the healthy 4.6% offered by Bank of America.

One step forward, two steps back
However, comparing stocks strictly on the basis of yield is a foolish -- note the lowercase "f" -- venture. Sure, if all things were equal, we would always invest in the company that offered the highest yield. Unfortunately, though, all things are never equal. Often, a high yield is nothing more than the result of a stock that has nosedived. Furthermore, dividends are never guaranteed, and can be lowered, suspended, or discontinued entirely at any time.

What good is plunking down money on a high-yielding stock if a struggling company is forced to slash its quarterly payments to meet other obligations? To that end, it's always a good idea to make sure that a firm's operations are on sound footing -- otherwise those large payouts will soon become unsustainable and could quickly crumble away.

Finally, one company is inevitably going to see better share performance. Therefore, we must also look at the factors that influence share price -- valuation, cash flows, earnings growth, profit margins, debt levels, and other fundamental criteria. Overlooking or downplaying deteriorating financial health just to capture a higher dividend -- which yield-hungry investors are unfortunately prone to do -- can be a costly decision.

Those who blindly plunge into stocks with tempting yields may want to consider the plight of a company like General Motors (NYSE:GM). While the firm has faithfully maintained a dividend yield of 4% to 5%, those payments have been more than offset by dismal share performance that has been sharply negative in four of the past five years. As a result, the stock has a trailing five-year annual return of -9.7% -- and that's including the dividend.

The whole is greater than the sum of its parts
Total returns are a function of both dividend distributions and capital appreciation. Cashing a few hefty dividend checks will ultimately be of little consolation if weakening financial results trigger a collapse in the shares. A steady dividend yield of 6% can be great, but not when the underlying stock is retreating by 7%. On the other hand, a rising stock can look even better when topped with a respectable dividend.

For example, notice that Bank of America's yield has not changed much since its 2000 levels, despite the payout nearly doubling from $1.03 to $2.00 per share. When the dividend is rising but the yield is not, the shares must be gaining ground as well. In fact, the stock has nearly doubled from the split-adjusted $22.52 that it closed at on this very date in September 2000. Not surprisingly, the shares have delivered a market-beating total return -- including both dividends and capital appreciation -- of 14.6% annually over the past five years.

Putting it all together
Companies with rock-solid fundamentals and a generous dividend offer investors the best of both worlds -- a dependable income stream and significant upside potential. That's why we launched the Motley Fool Income Investor -- an entire newsletter devoted exclusively to finding such investments. Lead analyst Mathew Emmert goes to great lengths to single out promising companies with attractive growth prospects as well as sizeable dividend yields. Since the newsletter was introduced, the portfolio has delivered an impressive total return of 15.98% per year, easily topping the 9.49% gain of the S&P 500.

Understanding that yield is a major component of total return is easy enough; putting that knowledge to work in your portfolio is the real test.

To date, Motley Fool Income Investor has recommended more than 40 companies that are not only beating the market but trouncing it by at least 10 percentage points. To discover these textbook examples of total return, join us for a free 30-day trial, which will give you full access to everything we've ever published.

Fool contributor Nathan Slaughter never really liked multiple-choice tests. He owns shares of Bank of America, but none of the other companies listed. The Fool has a disclosure policy.