Let’s say you invest $1,000 into Joeâ€™s Ice Cream company by buying 10 shares, each at $100 per share. It’s a well-managed firm that has a P/E ratio of 10, and a payout ratio of 10%, which amounts to a dividend of $1 per share. That’s decent, but nothing to write home about since you receive only a measly 1% of your investment as dividend.
However, because Joe is such a great manager, the company expands steadily, and after several years, the stock price is around $200. The payout ratio, however, has remained constant at 10%, and so has the P/E ratio (at 10); therefore, you are now receiving 10% of $20 in earnings, or $2 per share. As earnings increase, so does the dividend payment, even though the payout ratio remains constant. Since you paid $100 per share, your effective dividend yield is now 2%, up from the original 1%.
Now, fast forward a decade:
Joe’s Ice Cream Company enjoys great success as more and more North Americans gravitate to hot, sunny climates. The stock price keeps appreciating and now sits at $150 after splitting 2 for 1 three times. This means your initial $1,000 investment in 10 shares has grown to 80 shares (20, then 40, and now 80 shares) worth a total of $12,000. If the payout ratio remains the same and we continue to assume a constant P/E of 10, you now receive 10% of earnings ($1,200) or $120, which is 12% of your initial investment! So, even though Joe’s dividend payout ratio did not change, because he has grown his company the dividends alone rendered an excellent return–they drastically expanded the total return you got, along with the capital appreciation.
For decades, many investors have been using this dividend-focused strategy by buying shares in household names such as Coca-Cola, Johnson & Johnson, Kellogg, and General Electric. In the example above we showed how lucrative a static dividend payout can be; imagine the earning power of a company that grows so much as to increase its payout. In fact, this is what Johnson & Johnson did every year for 38 years (since 1966)! If you had bought the stock in the early 1970s, the dividend yield that you would have earned between then and now on your initial shares wouldâ€™ve grown approximately 12% annually. By 2004, your earnings from dividends alone would have given a 48% annual return on your initial shares!