If you're more than a few years away from retirement and interested in investing in stocks, you probably focus on looking for companies that fall into one or both of these two categories:
- Companies poised to undergo significant growth in coming years.
- Companies selling at a discount to their intrinsic value.
If so, you may not have put much thought into looking for companies with fat dividends. Many people feel that dividend-paying stocks are for older folks, folks near or in retirement who like the relative stability and income stream that comes with owning dividend-paying blue chips that grow slowly from year to year. The thing many of us miss is this: if you reinvest those dividends, that "slow" growth can suddenly look pretty good -- and if you buy the right stocks, you can get those great returns with below-average volatility. Great returns with low risk? It's possible -- read on.
The basics
Companies that generate excess cash (otherwise known as "profits") can do a few things with it: They can reinvest in their business, buy back their own stock, acquire other companies, pay their senior executives giant bonuses, or pay their shareholders a dividend. That dividend, which can be paid monthly, quarterly, or annually, comes directly to you, the shareholder, and can be reinvested or paid out as cash, at your option. If you direct your brokerage firm to reinvest, they'll take that money and buy you more shares of the stock.
For instance, instead of 400 shares of Coca-Cola (NYSE:KO), which has a dividend yield of 2.5%, you'd end up with about 410 after a year of dividends. Combine this with the stock's capital appreciation -- its increase in market value -- and you can end up with quite a big gain over time: If you had bought those 400 shares of Coke a year ago, not only would you have seen the price go from about $44 to about $54, you'd have 10 more of those $54 shares than you started with -- and your investment would have grown from $17,600 to $22,140, a 26% return on a 23% increase in price.
Pretty neat, huh? Over the long term, that little bit extra can add up to a big advantage. As Fool Dayana Yochim pointed out the other day, it's common to read that the stock market has gone up about 10% a year over time. What most of us forget is that historically, only about 6% of that has come from capital appreciation. The rest? You guessed it: those dividends. Over time, the effect is incredible: Wharton School professor Jeremy Siegel once pointed out that if you'd been invested in stocks over the last 100 years, reinvesting all dividends, about 97% of your wealth at the end of the period would be attributable to dividend reinvestment. I personally don't plan to spend 100 years saving for retirement, but his point is well taken.
Tracking them down
"So where," I hear you asking, "do I find these things?" Well, hang on a minute. Not every stock that pays a dividend is worth your investment. You still want to see a growth story or a discount to intrinsic value before you buy. A dividend isn't an automatic sign of success -- some companies pay a dividend because they've always paid a dividend and are afraid of how Wall Street would react if they stopped, even though they should really be reinvesting in their business. Other companies, particularly ones that seem undervalued, might be better served by buying back stock instead -- and the dividend could be a sign that management isn't on the ball.
But if you find a dividend payer that looks poised for steady growth -- solid long-term performers like JPMorgan Chase (NYSE:JPM) or Johnson & Johnson (NYSE:JNJ), for example -- look at it carefully. That steady growth might not look as exciting as finding the next hot biotech, but combined with the power of reinvestment and lower volatility, it might make you more money over time.
Want some help finding the best dividend payers? Consider a 30-day free trial of the Fool's Income Investor newsletter service. Your trial gives you full access to their recommendations, currently outperforming the market by over 5%. There's no obligation to subscribe.
Fool contributor John Rosevear invites you to write to him with your questions, comments, and ideas. He doesn't own any of the stocks mentioned above. Coca-Cola is an Inside Value recommendation. JPMorgan Chase and Johnson & Johnson are Income Investor recommendations. The Fool's disclosure policy doubles its dividend every year, without exception.
