The Power of Dividends

A Helpful Technique

One of my former professors, who was the #1 rated healthcare analyst in the world back in the early 2000’s, said something during a lecture that I will never forget. He said, “The best indicator for future stock returns is the dividend yield.” To elaborate: a comparative analysis of a company’s dividend yield to similar firms is the best way to determine the stock’s future returns.

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For Example

Say you have a publicly traded company, which we will call Company A, and its current dividend yield is 4%. Its stock price is $50. The average dividend yield for other companies in the industry is 2%. Assuming Company A is financially healthy, the stock price would have to increase to $100 per share for its dividend yield to be the same as the overall industry’s dividend yield. This would be a dramatic price increase, and it would probably take time for the stock to move that high. However, by basing your investment decisions on dividend yield, you can obtain a margin of safety which can help protect your portfolio from future losses.

Limitations

Of course, a sound investment operation requires more than just analyzing dividends. Stocks with dividend yields significantly higher than the yields of similar stocks usually indicate financial distress. But when the difference in dividend yields is only a couple percent, it can generally point you in the right direction for investment decisions.

This analytical technique does not work for non-dividend paying stocks. For companies that do not pay dividends, the stock price is determined by growth. Determining growth prospects for companies is a very difficult task, and most investors would be better off by not trying to beat Wall Street at its own game. Dividends provide an income stream, and dividend reinvestment can help you compound your portfolio’s returns. As Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it earns it … he who doesn’t … pays it.”

Disclaimer: This post represents my opinion, and it is not investment advice. Consult with a registered investment advisor before making any investments or trades.

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