Dividend income is a critical consideration when calculating “total return”. Unfortunately, it seems far too many investors mistakenly believe that total return merely consists of the change in price of an investment (e.g. the period of time between when they first bought a stock, and sold the stock). If the market price is higher than the cost basis, there is a capital gain. Total return on an investment can simply be defined as one that includes capital gains or loss, as well as income from interest and dividends, over a given period of time.
For example, an individual purchases 200 shares of stock at $15 a share. The stock price goes from $15 to $40 in 4 years. The individual made a $5000 profit! Right? Well, not exactly. If the stock also paid an annual dividend of $1.00 a share, then the collection of dividends also needs to be included in the computation. Furthermore, what if the dividend was increased annually for the next 3 years by 0.15˘ each year while the individual held the stock for 4 years. The dividend income for the 4 year period would be as follows: $200, $230, $260 and $290 for a combined total of $980.00. The actual total return would be $5980.00!
During the go-go period of the late 1990's, particularly at the height of the high-tech boom, many investors looked upon dividend-paying stocks with tremendous disdain. Dividend stocks were dull, stodgy investments. They lacked the high octane growth prospects that technology stocks potentially offered. Dividend-paying stocks were part of the “old economy”. Exciting start-up internet companies which offered the potential opportunity for quick, large capital gains were the leading stars of the “new economy”. Many individuals who invested heavily in risky, high-tech companies (most, if not all of the internet companies were without any track record of proven earnings) were never able to recoup their losses. In some cases, entire portfolios were wiped out because overly enthusiastic investors did not bother to heed the basic investment principles of diversification, and risk versus reward. It is interesting to note that the bursting of the internet stock bubble led those same investors stampeding towards more conservative, income-oriented investments.
Stock dividends are advantageous in that the dividend income can serve as a cushion for investors during bear markets. In fact, there are some individuals who will refuse to invest in companies that do not pay dividends.
It is also equally important to note that companies are not required to pay dividends. Dividend payments are not guaranteed. A company can, at any time, issue a special dividend, increase, reduce or even eliminate a dividend. Potential investors should also be wary of companies that pay an excessively high dividend in relation to its earnings and in comparison to the overall market. An abnormally high dividend payout can serve as a “red flag”. Sometimes, a company will hide its financial problems (i.e. an unusually exorbitant debt load, lack of profitability or inability to compete with its peers in the same sector for market share) behind the mask of an abnormally high dividend payout.