Thursday, July 3, 2014

Dividends Are A Return Of Capital And A Return On Capital

Dividends Reduce Risk

I often espouse the benefits of investing in companies that regularly pay and raise dividends. Of course, there are a number of reasons I do so, and I try to share these reasons as much as possible.
Today I’m going to show you how dividends reduce risk by functioning as both a return of capital and a return on capital.
There’s a difference between the two, but how does that work?
A return on your capital is simply a return on investment (ROI). You invest money in something that produces a return, and that return is your ROI. It doesn’t matter if this investment produces income or simply appreciates in price. Let’s say you buy a stock that pays no dividend:
You pay $1,000 for 10 shares of ABC Company at $100 per share. A year later you sell your 10 shares for $1,200. I’m going to leave out taxes and commissions for the sake of simplicity. So the $200 profit from the sale is your ROI. That’s a 20% return over the course of one year, which isn’t bad at all. Repeat that over and over again and you should do well.
Now, that scenario worked out pretty well. You likely had to stomach some ups and downs in the meanwhile, but all of your initial capital was returned to you, with a nice profit to boot.
But what happens when that asset doesn’t appreciate?
Let’s say you bought those same 10 shares ($100 per share) of ABC Company for $1,000, but a year later the company announced something Mr. Market didn’t like and those same 10 shares are now worth only $800. You decide to sell on the news as the fundamentals have changed and you net a ($200) loss on your investment. So you just took a 20% haircut, meaning your ROI is -20%. You not only didn’t receive a profit, but you also took a loss on some of your capital. The capital you now have to reinvest elsewhere is smaller.

Dividends Act As A Buffer

Stocks that do not pay any dividends means your returns are completely at the mercy of Mr. Market. I like to say dividends act as a kind of “buffer” between the market and your capital, and that’s becausedividends flow directly from a company to you as a shareholder. They bypass the stock market altogether, and so that’s why you’ve got this interesting relationship going on where they function as both ROI, but also a return of your capital.
When you invest in a company that pays a dividend (even better if they raise it regularly) you’re receiving capital directly from the company. No matter what happens to the company’s stock price, that company is sending you money back. Slowly the capital you initially invested with the company is being directly returned to you in the form of regular dividend payments. So the share price may oscillate wildly affecting the eventual outcome of your ROI (if you ever sell), but your risk is being reduced one dividend check at a time because the capital you initially invested is slowly being returned to you. Eventually, if you hold on to the investment long enough and the company continues to pay dividends during that time frame, all of your capital will be returned to you, meaning any share price appreciation comes with essentially no risk on your part.
Even while dividends do affect your total return as they’re added on to any capital gains you may or may not receive, they also function as a return of your capital as a company you buy shares in sends you regular dividend payments.
So let’s get back to that earlier example, using the first scenario. This time, ABC Company pays a $3.00/year dividend per share (3% yield).
In the first circumstance, you seen the share price appreciate from $100 to $120, but now you also collected $3.00 per share in the form of a dividend. So your ROI was boosted slightly to 23% – 20% from capital gains and 3% from the dividend. In this scenario, you collected $3.00 per share directly from the company and $20.00 per share in capital gains. So not only are you left with $1,230 when all is said and done in terms of your total return, but the $30 you received directly from the company means the capital you had at risk, even if the company went bankrupt, is only $970.
Do you see how that worked? 

Real-Life Example

If you didn’t understand quite how that worked, I’m going to use a real-life example to illustrate my point. And I use this example because I work better with real, working models. Hypothetical examples are nice, but anyone can massage numbers to make their point.
Philip Morris International Inc. (PM) is the second largest investment in my personal portfolio.
I accumulated shares in this tobacco giant over the course of three years, starting in January 2011 and my latest purchase coming in January 2014.
I’m including a screenshot directly from my Scottrade account so you can see accumulation in action:
PM
I spent $7,927.55 of my own capital in my accumulation of 115 shares.
Of course, it’s wonderful news that these shares are currently worth $10,147.02 (as of this writing).
But you know what’s even better?
I’ve received a total of $860.25 in dividends during my ownership tenure.
That means my return on capital is boosted, as the total return on my capital isn’t calculated from the difference between $10,147.02 (current position value) and $7,927.55 (cost basis) – which would be 28%. Rather, my total return is calculated from the difference between $11,007.27 ($860.25 + $10,147.02) and $7,927.55 – which would be 38.8%.  So my ROI is higher than it might look on paper due to the dividends I’ve received over the last three years.
But there is also a return of my capital.
See, no matter what happens to Philip Morris from here the capital I have at risk right now is only $7,067.30, and that’s because Philip Morris has sent me checks that total up $860.25. It doesn’t matter what Mr. Market might think of the company and its future prospects, the business itself has sent me capital. Eventually, if I hold the position long enough and they continue paying dividends, Philip Morris will send me so many dividend checks that they will add up to more than I initially invested in the company. At that point, my capital on the line is essentially $0. The company could go completely bankrupt at that point, and I still would have technically lost nothing. In fact, it’s quite possible with a business that pays you dividends long enough that even if it goes bankrupt and you hold all the way through bankruptcy (an unlikely scenario) you would still actually end up with a positive return. Imagine that!

Conclusion

This is a fantastic aspect of dividend growth investing that is rarely discussed, as I truly believe that dividends reduce risk as they function as both a return on capital (your ROI) and a return of capital (leaving less capital on the table). This allows you to slowly reduce your original capital’s exposure to Mr. Market’s madness, and over time could possibly leave you with none of your capital at risk, even while assets continues to churn out regular dividend payments to you while the equity ownership shares continue to also appreciate in value.
Of course, there are detractors to this belief as they may point out that any dividends that do not leave the company’s coffers could potentially leave the company in a better financial position and that capital could be invested elsewhere, propelling the share price by an equal amount. But I don’t invest for coulda, shoulda, woulda. I invest for real-life cash flow. And my Philip Morris example shows you not only how dividends can boost return on capital, but also return your original capital back to you in small pieces, essentially reducing your risk (via capital exposure) with every passing payment.
Full Disclosure: Long PM.
How about you? Do you believe dividends reduce risk in this way? 

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1 comment:

  1. I would say that leaving out the question of time value of money is oversimplification. Assuming a 10% opportunity cost (return), if you invest $100 and only get $5 a year back into infinity, you get only about $50 of present value.

    With your calculation, after 20 years you have all your capital back, so you get "infinite" return with those $5 flowing to you every year, while in reality you have suffered a loss (that is, a subpar 5% return compared to the assumed average 10% return).

    ReplyDelete

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