Last Updated on March 6, 2021 by Oddmund Groette
Dividend investing has become very popular. We believe this boils down to three factors:
- Dividends are a major source of the total returns. Research indicates dividends reinvested contributes to 40-50% of the total returns since WW2.
- The current risk-free interest rates are low and make the alternatives better.
- Many investors (wrongly) believe dividends have no opportunity costs.
Number one has been known for many decades. However, number two has really got a tailwind after the GFC in 2008/09. The US 30-year Treasuries currently pays a paltry 0.75%. Obviously, this is below the current inflation rate, and long-term investors in Treasuries must either risk losing purchasing power or hope the yield goes even lower. In the latter scenario, they can recoup by capital gains. The third alternative, opportunity costs, is difficult to calculate. But many companies could pay a dividend, but chose not to, like Berkshire Hathaway, for example. You should always ask yourself: Where does my capital compound the best, in my pockets or the company’s pockets?
What’s the alternative to Treasuries? The only alternative to increasing the “income” is to take a greater risk. Compared to Treasuries, stocks yielding 2-5% might seem like a good option.
Why invest in dividend stocks?
Dividend investors invest in dividend stocks because of two reasons:
- To have “income” from the dividend. Alternatively, the investor can reinvest the dividend into the same stock.
- When the dividend is distributed and paid out, the “principal” should keep up with the inflation rate.
Thus, many investors are looking to allocate more capital to stocks with a higher dividend yield to get “income”. They can live off the dividend while the principal keeps up with inflation. This way, you can live off the dividend in perpetuity. At least that is the theory.
We write “income” because a dividend is not really an income, it’s a distribution of shareholder’s equity. Make sure you don’t fool yourself into believing this is an “income” with no opportunity costs. Many companies could pay a dividend but chose not to. Why? Because the company believes it makes sense to invest in the business.
To understand dividend investing, you need to make sure you have one thing absolutely clear: How to calculate the dividend yield.
What is the dividend yield?
The dividend is set by the board of directors (BoD), and the rate depends on things like net earnings, cash flow, short-term liquidity, etc. As a small shareholder, you practically have no control of the dividend rate. It’s all up to the BoD.
If the BoD sets the dividend to 2.5 dollars and the stock trades at 90 dollars, then the yield is found by dividing the dividend by the stock price: 2.5/90. This number equals 0.0278. To get the percentage, you need to multiply 0.0278 by 100, which is 2.78. This means the dividend yield is 2.78%.
How to calculate the current yield on your portfolio:
To calculate the current yield on your portfolio, you must follow these steps:
- Open a spreadsheet and write down all your holdings and the number of shares you own. Summarize the values.
- Go to Yahoo!finance, for example, and find the current YEARLY dividend payment per share for all your holdings. If a company pays quarterly, multiply the rate by four. Summarize the values.
- Divide the amount in number 2 by the amount in number1. This is your dividend yield on your portfolio.
Let’s assume you only own three stocks:
- Company A: 100 shares trading at 85. The quarterly dividend is 0.63 cents (2.52 dollars annually).
- Company B: 150 shares trading at 95. The quarterly dividend is 0.79 cents (3.16 dollars annually).
- Company C: 300 shares trading at 36. The quarterly dividend is 0.11 cents (44 cents annually).
The value of your portfolio is 33 550 USD, and the annual dividends are 759 dollars. To find the current dividend yield on your portfolio, you divide 759 by 33 550. This is 0.0226, which equals 2.26%.
The dividend yield of your portfolio is 2.26%.
How to calculate the dividend yield on cost of your portfolio:
The yield on cost is simply the sum of what you paid for your current holdings. In other words, it’s what you initially paid for your shares when you purchased them. If we use the example from above, it might looks like this:
- Company A: 100 shares bought at 79. The quarterly dividend is still 0.63 cents (2.52 dollars annually).
- Company B: 150 shares bought at 66. The quarterly dividend is still 0.79 cents (3.16 dollars annually).
- Company C: 300 shares bought at 49. The quarterly dividend is still 0.11 cents (44 cents annually).
If we add the cost price of the three stocks we get 35 000. The dividends are still 759 dollars, and thus your dividend yield on cost is 2.33%.
However, the yield on cost of your portfolio is a pretty useless measure. Why is that? Because that is history and you need to consider the alternatives.
One piece of advice:
Instead of focusing on the dividend yield, look at total expected return. Many dividend investors make the mistake of investing in high yielding stocks. But high yielding stocks as a group have historically performed much worse than the stocks in the quintiles of 2-4 (1 being the 20% lowest yielding and 5 being the 20% highest yielding group).
Please read more about dividend investing on this link, which contains many articles about dividend investing in general: