By
Chuck Carnevale
:
In a previous article we postulated that "
Dividends Provide a Return Bonus
," a notion that we felt was so obvious as to almost be unworthy of
writing about. In fact, we felt that we were simply stating the
obvious. Therefore, we were surprised at the reaction the article
received, and have been even more surprised when
an article
was brought to our attention suggesting that dividends are
meaningless, or even detrimental to your net worth. The following
is a direct quote from the article:
"The dividend itself is meaningless to your net worth, or even
possibly detrimental if we take taxes into account, but let's not
open that can of worms. If you want, or need, the cash flow that
dividends provide, I'm not saying there's anything wrong with that.
I'm just pointing out that dividends play no part in your
profitability, and I
hope
that understanding this makes you a more informed
investor."
With all due respect to the author, we consider the above quote
both highly inaccurate and even preposterous. Dividends are an
extremely important component of an investor's profitability, and
to state otherwise is simply not supported by the facts. This
article is intended to provide undeniable evidence that dividends
enhance returns.
The Two Components of Total Return
The following is the definition of total return according to
investopedia:
"When measuring performance, the actual rate of return of an
investment or a pool of investments over a given evaluation period.
Total return includes interest, capital gains, dividends and
distributions realized over a given period of time.
"
With the above definition in mind, perhaps the best place to
start is by examining the two primary components of total return in
order to put everything in perspective. But before we go on, we are
utilizing the phrase "total return" as synonymous to the word
"profitability" as referenced in the quote above. In other words,
an investor's profitability logically must be measured as the total
return received on the investment. Total return is a function of
two primary components, capital appreciation and income. Of course,
investments that do not generate an income stream (dividends,
interest or distributions) will only possess the capital
appreciation component.
Capital appreciation (or depreciation) is simply the difference
between the price you originally paid for an investment, and the
price it currently can be sold at. More simply stated, it is the
increase in the price or value of your asset. Since our focus with
this article is on publicly traded common stocks, the capital
appreciation component represents the difference between the price
you paid and the price the stock currently trades at. For
non-dividend paying common stocks, this will be the sole source of
your total return. Capital gains are synonymous with capital
appreciation.
The second component of total return is the income component. As
stated in the definition, this will include interest, dividends or
distributions. Since we are focusing on dividend-paying stocks, we
will be analyzing dividends as our income component. At this point,
we should focus the reader to the fact that by the very definition
of total return, the income component represents a return in
addition to the capital gain or appreciation component. Therefore,
and again by definition, the dividend represents an additional
return above and beyond the capital gains. This alone adds credence
to the notion that dividends represent a return bonus as we had
postulated in our previous article.
Real-World Evidence Validating the Dividend
Bonus
We will utilize the
F.A.S.T.
Graphs™
(fundamentals analyzer software tool) as a vehicle for providing
clear, and we feel undeniable evidence, that dividends augment
total return. In order for us to accomplish this objective, it is
imperative that the reader clearly understands what the graphs are
depicting. Therefore, with our first example, Acenture (
ACN
), we will build the earnings and price correlated graph one
element at a time.
Accenture : Annualized Earnings Growth Rate 17.3%,
Capital Appreciation 14.4%
Accenture is a global management consulting, technology services
and outsourcing company. The orange line on the first graph plots
Acenture's fiscal operating earnings-per-share since 2003, and
represents the calculated intrinsic value of the company. The green
shaded area represents the total cumulative earnings that the
company has generated. The important fact for the reader to note
with this graph is that earnings have steadily increased at a very
high rate, with the exception of the modest flattening during the
great recession. As we will show next, these earnings are what the
market will capitalize in order to generate and calculate capital
appreciation for Acenture since 2003.
(click to enlarge)
With our next graph we add the element of monthly closing stock
prices overlaid and correlated to the orange earnings justified
valuation line. Since we are often accused of cherry picking, the
reader should note that this example, and all the other examples
utilized in this article, were hand selected based on valuation. In
other words, in order to eliminate any market mispricings or
anomalies, we are only reviewing companies where the beginning
price and ending price is at or near fair value based on the black
price line touching the orange valuation line.
When looked at in this manner, the source of capital
appreciation is vividly depicted without any market inefficiencies
or bias. Therefore, the reader can see that it is the earnings of
the company that drive stock prices over the long run. Moreover,
the reader can also see that the entire complement of earnings are
what the market is tracking. There is no adjustment being made for
dividends paid, which we will look at later. Once again, this
capital appreciation component (capital gains) is not affected or
adjusted by dividends in either direction. Furthermore, it is clear
that market forces will drive prices above the justified earnings
line and below it from time to time, but inevitably price always
moves back into alignment with earnings.
(click to enlarge)
The capital appreciation component for Acenture shows that a
$1000 investment on 12/31/2002 is now worth $3790.13. This is a
function of the share price rising from $17.99 to the closing price
on 11/23/2012 of $68.18. At this point, there is no dividend income
included in the calculation, just pure capital appreciation based
on earnings growth.
(click to enlarge)
With our next graphic, we now bring dividends (the light blue
shaded area) into the equation. Notice that we stack the dividends
on top of the earnings line even though they are paid out of the
green shaded area. This article, and the previous article that we
authored and linked to, provide an insight and justification for
why we present the graphs in this manner. It should be clear by
examining the graphic that all of the company's earnings are being
capitalized in order to create the capital appreciation
component.
It should also be clear that the dividend paid represents an
additional component to total return. By having the light blue
shaded area stacked on top, this reality becomes visibly apparent.
Furthermore, dividends do represent a return in addition to capital
appreciation thereby making an important contribution to
shareholders' total returns (profitability). The green and light
blue lines with dots at the end are color-coded showing the portion
of earnings paid out as dividends. The green line represents
earnings, the light blue represents dividends.
(click to enlarge)
We can now see the total return performance for Acenture, while
simultaneously examining each of the total return components,
capital appreciation and dividend income. Moreover, we can review
each of these components independently and then collectively. As we
previously reported, Acenture shareholders enjoyed a 14.4% annual
capital appreciation. However, in addition to capital appreciation
that closely mirrored the company's earnings growth, shareholders
received an additional $274.91 of cumulative total dividend income
(dividends paid out and not re-invested), which increased their
total annual return from 14.4% to 15.2% per annum.
The most important point here is that the capital appreciation
component would have been the same whether or not Acenture paid its
shareholders a dividend. Moreover, the dividend added almost a full
percentage point of annual return to the results.Dividends are
clearly a bonus, or a return in addition to the capital
appreciation component.
(click to enlarge)
Additional Evidence
The following earnings and price correlated graphs with
dividends are offered to provide additional evidence clearly
revealing the undeniable fact that dividends are a return
enhancement. In order to illustrate this as plainly as possible, we
will present three categories of companies ranging from low growth,
moderate growth, and finally fast growth. Then, for an even greater
perspective we will review a company that paid a very large special
one-time extra dividend.
As we did with the Acenture example, we will only utilize time
frames where beginning and ending valuation are in alignment with
the orange earnings justified valuation line. Therefore, the reader
can vividly see that the company's earnings growth rate drives its
capital appreciation component, and that its income component, the
dividend, provides an additional return.
But perhaps most importantly, it will be clear that the dividend
does not diminish the value of the company. The true worth of the
company is a function of its record of earnings growth as long as
fair value is in alignment both at the beginning and at the end of
the period. In other words, market mispricing biases are excluded
from the presentation.
Here are the key things to focus on as you review the following
earnings and price correlated graphs plus dividends examples. First
of all, notice how the black price line tracks and correlates with
the orange earnings justified valuation line. Then, notice that
dividends do not diminish or reduce the orange line (earnings).
Thecompanies' earnings (the orange line) are capitalized by the
market assigning the appropriate P/E ratio based on the company's
earnings growth. The P/E formula is price divided by earnings
(P/E), and not price divided by earnings minus dividends. Finally,
by stacking them on top, notice that the light blue shaded area
representing dividends paid out of earnings, the green shaded area,
are vividly depicted as return in addition to capital
appreciation.
When reviewing the associated performance graphs for each sample
company, notice how the company's capital appreciation component
will correlate very closely with the company's earnings growth
rate. This clearly validates the fact that earnings, all earnings,
drive the stock price. Moreover, recognize that the company's full
complement (total earnings) of earnings are capitalized generating
the capital appreciation component. Then, notice how the income
component, or the dividends, provide the additional return, which
augments and enhances the capital appreciation component.
Low Growth Examples
Vectren Corp: (
VVC
): Annualized Earnings Growth Rate 1.9%, Capital Appreciation
1.6%
Vectren Corporation is an energy holding company with
headquarters in Evansville, Indiana. Since our low-growth examples
(5% earnings growth or less) generate low capital appreciation
because earnings growth is so low, the importance of dividends is
vividly revealed. As a reminder, notice that the full compliment of
earnings (the orange line) are capitalized by the market. This is
especially illuminating when you consider the high payout ratios,
which are common with low-growth companies. In other words, even
though these companies pay out very significant portions of their
earnings, the capital appreciation component is still based on the
company's total earnings reported.
(click to enlarge)
(click to enlarge)
WGL Holdings, Inc.: (
WGL
): Annualized Earnings Growth Rate 2.7%, Capital Appreciation
2.4%
Washington Gas distributes natural gas to customers in the
District of Columbia, Maryland, and Virginia.
(click to enlarge)
(click to enlarge)
Moderate Growth Examples
The following moderate growth examples (8% to 12% earnings
growth) generate capital appreciation that is highly correlated to
the company's earnings growth rate. Once again, all earnings are
capitalized, and the dividend generates a return in addition to
capital gains. The reader might also notice that the big
differences here are lower payout ratios and a greater contribution
to total return from capital gains rather than dividends.
Nevertheless, the thesis that dividends provide a bonus return is
clear.
Baxter International, Inc.: (
BAX
): Annualized Earnings Growth Rate 9.9%, Capital Appreciation
9.6%
Baxter International Inc., through its subsidiaries, develops,
manufactures and markets products that save and sustain the lives
of people with hemophilia, immune disorders, infectious diseases,
kidney disease, trauma, and other chronic and acute medical
conditions.
(click to enlarge)
(click to enlarge)
Brinker International, Inc.: (
EAT
): Annualized Earnings Growth Rate 9.8%, Capital Appreciation
8.1%
Brinker International, Inc. is one of the world's leading casual
dining restaurant companies. With more than 1,500 restaurants and
over 100,000 team members in 32 countries and two territories,
Brinker and its brands see more than one million guests in its
restaurants every day.
The Brinker International Inc. example below offers additional
insight into the contribution of dividends to total return, because
the company did not start paying dividends until 2006. Therefore,
we can see the capital appreciation component was there even when
the company was not paying dividends. Moreover, we can see that
dividends added a bonus return above capital appreciation after
they were started.
Importantly, there are additional insights regarding the value
of dividends that the Brinker International Inc. example provides
us. From the dividend cash flow table on the performance report you
will see that Brinker International Inc. was able to continue
increasing its dividend each year even though earnings per share
and the stock price were falling.
(click to enlarge)
(click to enlarge)
Although the above earnings and price correlated graph with
dividends provides the illusion that dividends are dropping because
they are stacked on top of the falling earnings line (the orange
line), a review of the performance table shows that the payout
ratio increased because of the decreasing earnings, but that the
actual dividends themselves were increased each year.
The following graphs look at the time frame calendar years 2005
to 2010. We offer this graph to illustrate that during a period of
falling earnings and stock prices, the rising dividend income
component provided shareholders a buffer. Thanks to the dividend
income, shareholders almost broke even, therefore, the value of
dividends during difficult times is also highlighted.
(click to enlarge)
(click to enlarge)
Fast Growth Examples
The following fast growth examples (greater than 15% earnings
growth) provide compelling evidence that earnings growth generates
capital appreciation, regardless of whether dividends are paid or
not. On the other hand, by examining the long-term performance of
these companies we can clearly see that the dividends do provide a
return kicker.
Raven Industries, Inc.: (RAVN) Annualized Earnings Growth
Rate 19.9%, Capital Appreciation 23.1%
Since 1956, Raven Industries has designed and manufactured
high-quality, high-value technical products.
(click to enlarge)
(click to enlarge)
Ross Stores, Inc.: (ROST) Annualized Earnings Growth Rate
18.9%, Capital Appreciation 19.5%
Ross Stores, Inc. is an S&P 500, Fortune 500 and Nasdaq 100
company with headquarters in Pleasanton, California. The company
operates Ross Dress for Less® ("Ross"), the largest off-price
apparel and home fashion chain in the United States with 1,097
locations in 33 states, the District of Columbia and Guam.
(click to enlarge)
(click to enlarge)
Special Dividend Example
Coca-Cola Enterprises Inc.: (CCE)
Coca-Cola Enterprises is one of the world's largest Coca-Cola
bottlers operating locally in eight territories in Western
Europe.
Our final example reviews Coca-Cola Enterprises Inc. because the
company declared a large $10 special dividend in October of 2010.
With this example, it is clear that the ex-dividend date did cause
a huge temporary drop in the company's price due to its magnitude
(see red circle). However, we also see that the company's earnings
were not decreased and that the company's stock price eventually
moved back into alignment with its earnings. This picture provides
a stark and vivid depiction that dividends ultimately provide a
return bonus.
(click to enlarge)
The following graph courtesy of Google Finance shows that the
ex-dividend adjustment, even a very large one like a $10 special
dividend that Coca-Cola Enterprises paid out, can have less of an
impact on stock price than normal price volatility does. It is
clear that there is an adjustment, but it should also be clear that
normal trading activity soon renders the adjustment moot.
(click to enlarge)
The following earnings and price correlated plus dividends
shorter graph on Coca-Cola Enterprises dramatically illustrates the
dividend bonus concept we are writing about. With this graph, we
see capital appreciation generated by earnings, we see the
ex-dividend adjustment, as large as it was, soon mitigated, and we
see an in-our-face picture of the dividend bonus.
(click to enlarge)
When reviewing the performance of Coca-Cola Enterprises since
calendar year 2010, the year it declared a special $10 dividend, we
are provided undeniable evidence that dividends provide a bonus
return. From the graph above you will notice that initially there
was the ex-dividend effect, however, the stock price moves steadily
back into alignment with earnings even after such a large
ex-dividend adjustment.
But most importantly, the performance report shows that the
capital appreciation component correlated to (actually exceeded)
the company's total earnings growth. But even more importantly
still, we see that this huge special one-time dividend essentially
doubled the company's total return during this time frame. Clearly,
we see that the special dividend was indeed a bonus to
shareholders.
(click to enlarge)
Summary and Conclusions
Directly stated, dividends are one of the two major components
of total return, and they provide an enhancement of return to
shareholders that own them. Even more simply stated, two companies
that generate identical historical earnings growth rates will tend
to generate similar to identical capital appreciation components
assuming valuation alignment. However, if one of these two
companies pays a dividend while the other does not, the dividend
payer will provide total returns in excess of what the non-dividend
payer provides to its shareholders.
Not only is this common sense, we believe we provided ample
evidence within this article to clearly illustrate the veracity of
the above statements. Nevertheless, as compelling as the evidence
we provided is, we could have provided hundreds and even thousands
of additional examples. But that would simply have been overkill.
However, the only way that the evidence will resonate is if the
reader studies and analyzes the graphs in order to clearly
understand what they depict. If they do, they will find that they
support the hypothesis and the thesis of this article and our
previous article "
Dividends Provide A Return Bonus
."
Furthermore, whether a company can grow faster or not if it
retains its earnings and reinvests them in the company instead of
paying adividend is not a relevant issue. Some companies need to
reinvest more than other companies in order to grow. However, if
they don't need to invest all of their earnings, then paying them
out as a "bonus" to shareholders is a proper use of those earnings.
And, if the potential growth rate of the company is slowing, and
cannot be accelerated by throwing more money at the company, a
dividend component can provide additional shareholder compensation
to augment the company's lower capital appreciation potential.
When all is said and done, dividends are a very important part
of the total return potential of any given company. Very
fast-growing companies may need to retain their earnings in order
to fund their continued growth. These companies often provide a
high enough total return to reward shareholders even though they
don't pay a dividend. On the other hand, if the company's growth
rate slows, paying its shareholders a cash dividend is a great way
to reward them. This is especially true for those shareholders who
are in retirement or approaching retirement and looking for
spendable income. Dividends clearly pay a large and important role
regarding their shareholders' profitability, and to state otherwise
is simply balderdash.
Disclosure:
I am long [[ACN]], [[ROST]]. I wrote this article myself, and it
expresses my own opinions. I am not receiving compensation for it.
I have no business relationship with any company whose stock is
mentioned in this article.
Disclaimer:
The opinions in this document are for informational and
educational purposes only and should not be construed as a
recommendation to buy or sell the stocks mentioned or to solicit
transactions or clients. Past performance of the companies
discussed may not continue and the companies may not achieve the
earnings growth as predicted. The information in this document is
believed to be accurate, but under no circumstances should a
person act upon the information contained within. We do not
recommend that anyone act upon any investment information without
first consulting an investment advisor as to the suitability of
such investments for his specific situation.
See also
W.W. Grainger, Inc. - Sales/ Trading Statement
Call
on seekingalpha.com