Investing in dividend-paying stocks, especially those with high yields, can sometimes cause investors to focus too much on current income at the expense of total return.
Total return is one of the most important concepts in finance, and it involves more than just the dividends a company pays out.
Let’s take a closer look at how total returns are calculated, why total return is an important metric, and how dividend growth investing can help maximize your chances of generating healthy total returns over time to help you reach your financial goals.
What Is Total Return?
The total return of a stock is the total amount your investment changes in value, calculated by adding the amount of dividend or interest income received to the investment’s capital return (i.e. change in the investment’s price).
Total return is driven by three components: earnings growth (which fuels capital gains and the underlying intrinsic value of a stock), dividends, and changes in valuation multiples.
You can see below how these components have combined to generate real market returns across seven major economies from 1970-2011. Dividend yield (orange) and dividend growth (purple – approximates long-term earnings growth) have been major contributors to total returns around the world.
For growth stocks that pay no dividends, such as Amazon (AMZN) or Alphabet (GOOG), the total return is just a function of the company’s earnings growth and change in valuation multiple.
For example, if you bought Amazon back in 1997 at its split-adjusted IPO price of $1.73 per share, than your total return over that time would have been 58,358.96%, or 37.36% annually.
Of course Amazon happens to be the single greatest growth stock of the last 20 years, and it’s road from $1.73 to $1,011 per share has been fraught with truly gut wrenching volatility. For example, you would have had to hold on through some painful declines owning Amazon over the decades:
- 94% decline between December 1999 and October 2001
- 53% decline between October 2003 and August 2006
- 38% decline between October 2007 and March 2008 (before the financial crisis)
- 60% decline between August 2008 and November 2008 (financial crisis)
- 30% decline between December 2015 and February 2016
Keep in mind that these are just the 30%+ price declines. Over the decades Amazon has had about dozens more periods where shares fell 20% or more over a short period of time. That’s because, as the saying goes, “stocks take an escalator up, but the elevator down.” Periods of market panic can potentially wipe out years of capital gains in a manner of weeks or months.
And Amazon is hardly alone in this kind of volatility. Most of the greatest growth stocks have suffered similar crashes on their way to the history books. Imagine how you would feel if you owned such a stock and watched it crash 20%, 40%, or even 80%, undoing perhaps 10 years worth of gains in a matter of months.
Would you be able to stay calm and disciplined and dollar cost average on the way down? Or as Warren Buffett is famous for saying, “be greedy when others are fearful?”
Unfortunately the answer for most people is a firm “no.” That’s due to something called loss aversion, a psychological principle that states that it hurts twice as much to lose a dollar as to gain a dollar.
Or to put it another way, while it feels great to watch a stock rise 50% over a number of months or years, watching it crash 50% in weeks or months is far more traumatic and results in repeating cycles of euphoria and panic.
Fortunately, long-term dividend growth investing can refocus your mind away from the inevitable short-term chaos of the markets and help you to achieve your financial goals.
Dividends Have Contributed Substantially to Total Returns
Dividends have been a major component of the stock market’s overall total returns throughout history. As you can see below, dividends have contributed anywhere from 25% to 75% of the market’s overall total return over the past seven decades (the remaining portion of total return is accounted for by capital gains, or the market’s change in price).
Dividends, when reinvested into more shares over time, help compound wealth even faster. In fact, Guiness Atkinson Funds, a money manager, notes that “if you had invested $100 at the end of 1940, this would have been worth approximately $174,000 at the end of 2011 if you had reinvested in dividends, versus $12,000 if dividends were not included.”
That’s due to several powerful factors working together to create what I like to call “hyper compounding.”
Here’s how it works. Imagine you own a high-quality dividend paying company, such as Johnson & Johnson (JNJ). Historically management pays out about 50% of earnings and free cash flow in the form of dividends, which you can think of as your quarterly cut of the companies profits. You can use that cash to either pay expenses, such as to fund your retirement, or to reinvest into additional shares to gradually grow your stake in the company.
Johnson & Johnson’s cash flow has grown over time thanks to its acquisitions of competitors, expansion into foreign markets, and growing demand for its products thanks to an increasing and aging world population. That has allowed the company to boost its dividend for more than 50 straight years to become what’s known as a “dividend king.”
Even if you only buy the shares once, by reinvesting the dividends, such as through a dividend reinvestment plan (DRIP) or flexible reinvestment plan (FRIP), your share count will increase steadily over time. And because of J&J’s growing earnings and cash flow, each share will generate a larger income stream with which to buy more and more shares.
For example, if you had bought $10,000 shares of Johnson & Johnson 22 years ago you would have initially owned about 562 shares. However, due to the power of dividend reinvestment, today that single $10,000 investment would represent 930 shares, paying $3,125 in annual dividends (a 31.25% yield on cost) and worth more than 12 times your initial investment. In fact, your annual total return would have been 12.1%, far more than the S&P 500’s total return.
And Johnson & Johnson is hardly the only dividend growth stock to generate total returns in line with or better than the market’s. In fact, companies that have consistently grown their dividends over long periods of time, especially dividend kings, aristocrats, and achievers, have outperformed the broader market in recent decades, thanks in large part to dividend reinvestment. You can see the performance of dividend aristocrats compared to the S&P 500 below.
Better yet? Because investors buy dividend growth stocks for the income, they are less likely to panic and sell during periodic market downturns, even during market crashes such as we saw in 2000 and 2008 (when the S&P 500 suffered a 50%+ drawdown).
Many cash-rich businesses that are able to consistently pay dividends tend to be more defensive in nature, which has historically helped them outperform non-dividend paying stocks during bear markets. This helps make many dividend growth stocks less volatile than non-dividend paying growth stocks, which also partially explains why they tend to generate healthy returns over time.
In other words, dividend growth investing offers numerous benefits to maximize the market’s wealth and income compounding power. Companies able to consistently grow their dividends are likely to generate healthy total returns over time, and their generally lower volatility will help you sleep well at night, especially when the market starts to panic and decline.
That in turn can help you to think of your portfolio not just as a source of savings for the future but as an outright business, one focused not on quarterly earnings or daily price swings but on growing your cash flow (dividends).
How To Get Started In Dividend Growth Investing
It’s said that the journey of a thousand miles begins with a single step. The same is true with dividend growth investing. Far more important than timing the market (which almost never works) is time in the market. That’s because the longer your portfolio has to grow your share count and income stream, the faster your wealth will increase.
That’s why it’s vital to invest as early as possible. However, even if you’re older (or even already retired) and thus don’t have decades of time for compounding to work for you, dividend investing can still help you achieve financial success.
That’s because historical market studies have shown that a good rule of thumb for total returns is dividend yield plus long-term dividend growth. That makes sense because the value of a dividend growth stock is represented by both its current income and its future dividends, which generally grow along with its earnings and cash flow.
Of course valuation also matters, so in truth the total return formula is better modeled by: (dividend yield + long-term dividend growth) x change in valuation multiple (e.g. P/E ratio contracts from 20x to 17x). If you can find a high-quality dividend growth stock that’s also undervalued, then your wealth can benefit not just from a rising share price and a growing payout, but also from a recovery in a stock’s valuation that can further enhance performance.
Concluding Thoughts On Dividend Investing And Total Returns
Investing in the stock market is one of the greatest things anyone can do in order to become financially independent over the long-term, and dividend growth investing has historically proven to be a dependable wealth compounding strategy.
While that doesn’t mean that anyone’s success is assured, if you can follow a few simple rules like avoiding excess debt, having a strong personal finance profile, saving and investing consistently, and most of all, avoiding timing the market, then you will likely be well on your way to achieving your financial goals.
Dividends have contributed significantly to the market’s total returns throughout history, but there are no hard and fast rules that can guarantee any type of performance going forward. There are plenty of high quality companies that choose not to pay dividends in favor of total reinvestment back into the business (Warren Buffett’s Berkshire Hathaway comes to mind), and simply buying high-yielding stocks with the expectation that they will outperform thanks to their attractive dividends is not a prudent strategy.
There’s nothing wrong with buying higher-yielding stocks to generate current income for retirement, but it’s still important to keep the total return equation in mind when making investment decisions. Most stocks with high yields come with low or even negative long-term growth rates, reducing their total return potential, while the opposite is true for many stocks paying lower dividends today.
Rather than making a decision based on a single dimension of an investment opportunity (e.g. dividend yield or P/E multiple alone), try to maintain a more holistic focus that encompasses all of the drivers of total return and embrace the habits of effective dividend investors.