Understanding Dividend Yield

Understanding the definition of the dividend yield is the easy part, what it means to the dividend investor is a matter of the current inflation rate and the reasons for purchasing a company.

When evaluating stocks there are many metrics that can be used, some have great importance, and others have importance only in specific cases.  The dividend investor looks at the yield to understand what their cut of the proceeds will be.

Understanding the definition of the dividend yield is fairly simple, understanding what the yield means to the investor is another issue.

The dividend yield is the amount of the annual dividend payment divided by the stock price expressed as a percentage.  For instance, one of my favorite companies, AFLAC, offered quarterly payouts in 2019 of 27 cents each, so for every share owned, $1.08 was returned as a dividend.  AFLAC’s stock price, as I write this (21 Dec 19), is $53.14.  So $1.08 / $53.14 *100 = 2.3%, the dividend yield.

As the dividend yield is a comparison with the price, if AFLAC’s stock price moves up to $60 then the dividend yield will fall to 1.8% or if the price drops to $50 then the yield will rise to 2.16%.

Related to this is the dividend payout ratio, which is also important to understand.  The dividend payout ratio is a ratio of the total amount paid in dividends to the net income.  When a company makes a profit, that money goes toward dividends, debt reduction, cash reserves, and reinvestment back into the company.  The dividend payout ratio gives one an idea how much of the profit is being returned to the owners of the company, as opposed to being used for company purposes.

Understanding the implications of the dividend yield are much more difficult than understanding its definition.  After all, dividend yield is just a number, but how does one know if it is a good number.  And is there such a thing as a good dividend yield?

Unfortunately, the answer is one that we all too commonly hear – It Depends.

Reflexively one might think that the higher the dividend yield the better, after all, the higher the yield the higher the return.  But reality pokes its finger into this thinking when one realizes that the highest average dividend yield ever was during the Great Depression, not one of the favorite times for investors.

Thinking about the reason for a dividend in the first place might offer a hint as to what a good yield might be.  Companies oftentimes offer dividends to attract investors and create a demand for their stock.  This means that the dividend yield needs to be attractive enough to convince the investor to purchase the company’s stock.

If one if looking for a place to put their money where it would offer a return, saving accounts and money market funds offer so little that the only value they have is that the funds are ensured not to go down.  Of course, as of this writing the average money market interest rate is 0.18% and the inflation rate is 2.1%, so one actually loses about 1.9% with such an investment.

But that gives us an idea as to what the minimum dividend yield should be if one is purchasing the company solely for the dividend.  If the dividend does not keep up with inflation then one could actually lose money while gaining it.

With the current inflation rate of 2.1% that might be a good starting point for what one might consider to be a “good” dividend yield.

However, as stated above, this would be the case for one who is purchasing only for the dividend.  The company’s stock price should also be taken into consideration.

There is no magic formula for this – actually, some tout such formulas but I have seen these claims fall apart too many times.  Due diligence for company selection is beyond the scope of this dividend website, but I can offer a bit of research I have found helpful.

Although past performance is no guarantee of the future (how many times have we heard that, and it is true), I do like to see where the company has been, and I will use the example of AFLAC.

Looking at the historical stock price of this company we can see that over the past 10 years the average annual return with dividends reinvested is about 11%.  Since the company’s dividend yield is about 2% we can see that even if it was considerably lower, this would be an excellent company to select.  The fact that AFLAC is a Dividend Champion gives one confidence that the dividend has an excellent chance of sticking around in the future, which also speaks to the stability of the company.

Comparing the dividend yield to the current inflation rate is a good starting point for one when considering the purchase of a company when the expectation of the dividend is a major reason for the purchase.

Two Ways to DRiP – Part 2

The traditional means of DRiPping is perhaps not the best, but the option should at least be understood.

Choices are good, and if I were in the process of creating a DRiP portfolio then the means I described in the previous article would probably be the direction I would take.  That said, it is good to understand one’s choices, so I will explain the original approach I took years ago.

My grandfather worked for AT&T and over the decades, being an employee, he was able to accumulate a large number of shares of the company.  Each paycheck some of his money went to the company and was invested in their stock, with the dividends reinvested.  Generally speaking, this is the traditional means of participating in a dividend reinvestment program.

For one to be able to participate in a company’s DRiP they must initially be the actual owner of that company’s stock.  This is not as straightforward as one might think.  Purchasing shares of a company through a broker does not actually mean that one owns those shares – they do not – the shares are owned by the broker for the client.  This is called owning shares in street name.

Brokers hold stock in street name for convenience.  A lot goes into the transfer of stock from one entity to another, and were the broker required to convert ownership for every trade, the overhead would be time-consuming and costly.  Of course, owning stock in street name still gives the owner all of the rights that are afforded to the true holder of the stock.

To be allowed to participate in a dividend reinvestment program one must own a certain number of shares (usually just one) in the company.  This means that while one can make a purchase through a broker, they can only be the actual owner of the stock by asking the broker to transfer the stock to them.

This involves the issuance of a stock certificate, and there will probably be a cost associated with this.  For instance, looking at the fees listed on eTrade and TD Ameritrade the cost is $500 for the service, which sounds crazy to me, but their business model is one where the customer is expected to do most of the work, so it is something that is discouraged.  There was a time when this service was free but that time has probably passed.

Fortunately, there is a less expensive and more convenient way to do this.  DirectInvesting.com can make the purchase as well as enroll the customer in the company’s dividend reinvestment program for 1/10th of this cost (less if the company one wishes to purchase happens to be their monthly special).  I have used their service in the past and can attest to the convenience of not having to obtain a physical stock certificate, mail it to the company (which should be done with the added cost of using registered mail), and fill out the application form for the program.

Although all of the holdings in my DRiP portfolio were obtained through this traditional route, I cannot think of an advantage I hold over someone who has decided to obtain their shares through a discount broker like TD Ameritrade as outlined in the previous article.  Whichever route is taken, making numerous purchases of great companies over a long period of time and having the dividends reinvested will yield great benefits.

Two Ways to DRiP – Part 1

There are a couple of good ways to be involved with dividend reinvestment programs, and one bad way.

When I originally started writing about dividend reinvestment programs for The Motley Fool twenty years ago there were three ways to get started with DRiP investing.  The first means of doing this involved companies like BuyAndHold, which ended operations in 2015 and moved their clients to a folio investing solution.

I will not be covering folio trading in this series but will explain what it is, using Folio Investing as an example.

Folio trading allows one to create their own portfolio of stocks on the broker’s platform.  Folio Investing has groups of pre-selected portfolios that one can take as is, or can be modified to accommodate one’s preference to weighting.  Building a portfolio from scratch of specific stocks is also a possibility.

This does come at a cost.  Folio Investing’s least expensive plan sets one back $15 per quarter, plus $4 per purchase.  The basic plan allows only three trades during the quarter, which is a problem for those whose strategy is to make multiple purchases each month.  This limitation can be accommodated on their platform, but doing so moves one to the more expensive plan, which rockets the cost to $29 per month (or $290 per year).

As one who seeks to minimize costs (which is one of the real powers with dividend reinvestment plans), this just does not work for me.

The first way to DRiP that does make sense is to work through a broker, not something that would have been feasible years ago.  This does not fit into the traditional mold of dividend reinvestment programs but achieves its goal in the same manner.  For this example I will look at TD Ameritrade.

The TD Ameritrade website indicates that they offer everything the DRiPper seeks to accomplish.  Their platform advertises fee-free purchases of stock, so multiple purchases of companies could be done each month.  The company also offers a dividend reinvestment program without cost, so that barrier is reached.  And finally, partial shares can be owned.

There may be limitations on these offerings that do not work.  For instance, when making a purchase one needs to specify the number of shares as opposed to the purchase amount.  This means that you cannot purchase fractional shares.  If you wish to invest $100 and the share price is $51 then the $49 will need to wait for another day.  That said, for the advantages TD Ameritrade offers, this is probably going to be an acceptable limitation.

At the time of this writing (10 Dec 2019) there could be a small catch.  TD Ameritrade is going to be acquired by Charles Schwab.  Although I could not find information anywhere on Charles Schwab’s website, I spoke with a representative who told me that they do have an option to reinvest dividends and hold fractional shares, so this may not be an issue.

I have had experience with this in the past.  I originally purchased stocks through a company (long forgotten) that was acquired by Zecco, which was then acquired by Ally.  The reasons for selecting a company to do business with may not be transferred to the new company, so one simply needs to be aware of the situation and be ready to reevaluate their decision.

The second part of this article will deal with the more traditional means of participating in dividend reinvestment programs.

The Dividend Yield and Stock Price Connection

Buying for the dividend, in the long term, is also buying for the stock price.

Fads dominate financial magazines.  A quick survey of current editions will often show recommendations of hot stocks and successful mutual funds to purchase right now.  Of course, this year’s successful mutual fund manager may not have this success last into the next year.

The magazine’s stress is on immediacy, which makes complete sense for them.  After all, they need to sell the magazine and next month they will again need to do the same.  Long term purchases are boring and by definition do not need to be changed every month, and that does not sell magazines.

The extreme fad would be day trading.  This has nothing to do with investing and is very stressful.  With immediacy paramount, stocks are purchased and held for mere days or even minutes.  Even if one is able to turn a profit (unlikely, as a study of day traders in Taiwan showed that 80% lose money), the amount of work in simply reporting the transactions to the IRS must be very time-consuming.

The investor’s chief problem – and even his worst enemy – is likely to be himself. – Benjamin Graham

For the long term investor the opposite exists.  Whereas day traders only consider factors for the very short term, dividends are important to the long term investor.  One might think that the stock’s value is the only important issue at hand, but ignoring the importance of the dividend is a real mistake.

As an example, $10,000 invested in the S&P 500 in December 1960 would have yielded a value of about $430,000 – not a bad return on investment.  However, the total return including reinvested dividends would have been almost $2,500,000, more than five times greater.

This shows that not only is it worthwhile to reinvest dividends, but hints that there may be a linkage between price and dividend growth, and indeed this is the case.

The dividend can act as the proverbial canary in a coal mine as far as understanding the health of the company is concerned.  After all, the dividend is real money.  Regardless any accounting tricks that can be employed to obfuscate or deflect accounting numbers in the quarterly report, hard cold cash cannot be denied.

A continually rising dividend rate is a reflection of the fact that the company can at least pay that money to their shareholders.  Companies can only increase dividends when they know that future cash payments will be sustainable.  Companies that cut or suspend their dividend are offering a tell that the future of the company may not be as rosy as they let on to be.

The linkage between a growing dividend and rising stock price not only makes sense, but research bears this out, showing a correlation of close to 90% over 25 year cycles.  So as the dividend grows, the price of the stock is more than likely to move in the same direction.

It is amazing that this is a fact that tends to get lost.  Looking for the next stock tip and hoping to find a clue that will allow one to buy low is a common goal for investors.  However, for those looking to advance over a long period of time, it could be that finding the safety of a dividend is the best long term bet.

This underscores the significance of the Dividend Champions List as a great starting point for finding a company in which to invest.