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Wednesday, July 8, 2015

Simple Math Showing the Power of Dividend Growth Investing

I have seen countless articles about Dividend Growth Investing (DGI) but I have never found one that presented a very simple example and why it is so powerful. I wanted to do the math to see for myself. The answer to the simple math is Yield On Cost. That is the current yield you are receiving based on the initial cost of your investment. Let's jump in.
  
Many look at a stock like Coca Cola (KO) and ask why someone cares about a 3% dividend. I get that and I asked the same question at one point. Here is why a Dividend Growth Investor cares:

In 2005, KO was selling for roughly $20 per share. If you invested $10,000, you would then own 500 shares of KO. Simple:

$10,000 / $20 = 500 shares

Now lets say you set your dividends to automatically invest back into KO at the current price. I have over simplified the calculation because the price doesnt remain the same throughout the year, so I took an average. Each time KO pays a dividend, you use that dividend money to buy MORE shares of KO. This is great, right! KO is basically granting you more shares of their stock for FREE (minus fees to reinvest). Continuing our example, in 2005, KO paid a yearly dividend of $0.56 per share. That would give us $280 in yearly dividends:

500 shares * $0.56 = $280 yearly

The current price of KO the next year, in 2006, was around $22 per share. So using that $280, you could then buy more KO, as explained above:

$280 / $22 = 12.73 shares of KO

Something interesting happened at KO though in 2006, they raised their dividend from $.56 per share, to $0.62 per share. So comparing yields based on the current price you get:

$.56 / $20 = 2.8% (2005)
$.62 / $22 = 2.81% (2006)

Interesting isn't it. The dividend increased with the price (and also EPS if we look at that). What is even more interesting is that you havent invested any more money than your original $10,000.... we only reinvested the income from our current 500 shares. So that means in 2006, our Yield On Cost would be:

500 shares + 12.73 Shares = 512.73 Total shares
512.73 shares * $.62 = $317.89 Current Yield

 Now divide the Current Yield by the initial investment:

$317.89 / $10,000  = 3.18% = Yield on Cost

I am not convinced that it is important to add in the Dividends that were reinvested. Technically when you get paid dividends and choose to reinvest them, it is changing your cost basis but considering you are not adding any additional funds, then I like to omit it and look at what my initial investment is making now. 
So in year 2005, the Yield On Cost was 2.8% and one year later in 2006, the yield jumps to 3.18%. If you continue this pattern for 10 years, you get a YOC of 8.58% on KO. That means that your  investment of $10,000 in 2005, without adding any additional funds to it, is now earning you $858 every year (and more if KO keeps increasing their dividend).

Here is the chart of the actual data from 2005 to 2015 for KO:


KOQ Div% incYear DivPriceYield on CostSharesStock ValueYearly Dividends
20150.338.20%$1.32438.58%650.21$27,959$858.27
20140.3058.93%$1.22427.71%632.27$26,555$771.37
20130.289.80%$1.12386.90%615.85$23,402$689.75
20120.2558.51%$1.02366.12%599.75$21,591$611.74
20110.2356.82%$0.94345.49%584.49$19,873$549.42
20100.227.32%$0.88305.01%569.74$17,092$501.37
20090.2057.89%$0.82254.55%554.58$13,865$454.76
20080.1911.76%$0.76264.09%538.22$13,994$409.05
20070.179.68%$0.68273.57%524.50$14,162$356.66
20060.15510.71%$0.62223.18%512.73$11,280$317.89
20050.14
$0.56202.80%500$10,000$280.00

Conclusion:

In conclusion, while it is good to look at the current yield of a stock, don't be discouraged if it is only 2% or even lower. Instead, you should focus on the dividend history or a company to look at how much they have increased the dividend over time.

It is also important to note that reinvesting the dividends in a company (whether its the same company or a better valued company at the time) takes advantage of compounding and helps your money grow faster.

The above case for KO is an ideal case because the stock price rose from 2005 to 2015. It also has increased dividends consistently. That doesnt mean the above breaks if the stock you are buying stays at the same price over time, it just means you have to evaluate the reason for the price stagnation and if you want to continue investing in the company.

Dividend Growth Investing takes time to harness the power of compounding and increased Yield on Cost. The hope is that during the growth phase, you are buying companies that will increase their dividends over time and therefore increase your Yield On Cost as well!

Disclaimer: Long KO. 

6 comments:

  1. One of the great reasons I love this investing lifestyle... Getting more money and not having to work for it is a great plan for success

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    Replies
    1. Hi ADD,

      It sure is! It's sort of a difficult concept to wrap your head around until you start looking at the data. Everyone knows that compounding is a powerful tool but not always how to apply it. Thanks for the comment!

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  2. Hard to not like the ever increasing yield on cost as long as the company is increasing their dividend payout.

    ReplyDelete
    Replies
    1. Hi Tawcan, it is easy to love for sure!

      Delete
  3. Pretty cool to see this in math terms. While I understand the concept and have done the calculations myself, I really like the Yield on Cost metric. It would be interesting to see transaction costs in there, but for the most part that is very cool to see the yield increase 400%.

    Have a good day and thanks for the informative article,
    Erik

    ReplyDelete
    Replies
    1. Hi Erik,

      Yes transaction costs can eat up yield for sure. Need to be careful. It would be interesting to see the impact. Future article idea. :) thanks! Glad you enjoyed it and thanks for the comment.

      Delete