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THE STRATEGIC DIVIDEND INVESTOR
By DANIEL PERIS
The McGraw-Hill Companies, Inc.Copyright © 2011Daniel Peris
All rights reserved.
Why Invest for Dividends?
What Is a Dividend?
Let's start by turning off CNBC, putting down the Wall Street Journal, and considering what an investment really is. You are turning over money to someone or something in expectation of getting a return greater than the cost you may have incurred to raise the funds or greater than what alternate investments in a similar endeavor (e.g., stocks, bonds, real estate, private equity, or a hot dog stand) might produce. If it is structured as debt, you are lending money in return for a stated percentage from the coupon and your principal back at a later time. In the open market, the price of the principal may fluctuate somewhat, but the return that you receive is basically the coupon and then your money back. Defaults on principal are rare, and the risk of default is, in theory, priced into the principal.
Stocks are not much different. You are providing capital to management in return for a small ownership stake in the company—hence the name "equity." It is a share of the company's assets that remain after the company has satisfied its obligations, such as debt and accounts payable. Unless purchased at an initial public offering or at some other capital raising, you are generally buying your stake from a third party rather than from the company itself. Unlike debt, equity has no maturity date. The stake in the company will belong to you in perpetuity unless you sell it to someone else or the company itself is purchased or goes out of business.
A company invests the capital that it gets directly from investors however it sees fit, but with an expectation that it will generate a return greater than it spent to raise that capital. Small, early-stage companies may not have any near-term positive return. They generally should rely on the cozier and more risk-oriented world of private equity. Larger and more established companies—those whose equities are publicly traded on and dominate the stock market—will usually have a positive return from their businesses. That is, they earn profits. Depending on the industry and the company's stage of development, some of those profits will be reinvested back into the business. But the excess profits belong to the owners of the company—the shareholders—and are (or should be) distributed to them in the form of dividends. That's why people should invest in stocks: to access streams of distributable profits in the companies that they own. Why else would you want to own a stake in a large corporation if not to share in the profits and to get them in cash?
Investors have become accustomed to hearing a different answer to that question: you buy stocks because you believe that they will "go up" and you can sell them for a gain. But think about it. Stocks go up presumably because the business is worth more. A business is necessarily worth more if it has large and rising distributions of cash to company owners. Unless you subscribe to a vast greater-fool theory—where someone is always willing to buy something from you for more than you paid for it regardless of its "worth"—the final purchaser of a stock has to be buying the security with the expectation of holding it in perpetuity based on its intrinsic value. If you are holding a stock with no expectation of selling it, the only value it can possibly generate for you is through the cash that you receive from it: the dividends. In the daisy chain of buyers and sellers, it all comes down to cash. If the last buyer can't justify the purchase based on the cash received from holding on to the business permanently, he or she would not (should not) buy it, and the daisy chain unravels back to the first buyer.
In that regard, investing in stocks is not much different from purchasing rental property. You buy it and perhaps fix it up. That's the capital that you've invested. You lease out the apartments or the commercial space. What's left after you've paid the expenses is the return on your investment. Whether through improvements, a bit of inflation, or your savvy in choosing a property in an up- and-coming neighborhood, your rents go up modestly year after year, as does the value of the property should you choose to sell it to someone who is making the same calculation. If you don't choose to sell it, you continue to benefit from the rising stream of rents.
The basic math applies to any persons running their own business. They've put time, energy, and actual money into it. For a period they have probably endured losses and then reinvested all the early profits back into the business. (At this stage, it can be quite hard to determine what the business is really worth.) But as the business matures, they begin to take out cash distributions, and the value of the enterprise continues to grow in line with those distributions. I've often commented to our clients that if we could easily tap into the rising distributable profit streams of local private businesses—say the dry cleaner on the corner, the bakery down the street, the dentist's office by the school, for instance—we would consider it. But the reality is that to access dividend streams and to still permit investors to enter and exit in a timely fashion, we have to rely on companies where the equity is priced and available on a daily basis—the stock market. But you should not confuse the means with the end: you don't want to invest in the stock market; you want to invest in companies through the stock market. Over the past two decades, our society has made a fetish of stocks rather than seeing them for what they are: a flawed but ultimately practical means of accessing distributable profit streams from corporations in return for providing capital to those same corporations. For many investors, however, the market has become an end unto itself: a platform to try to "buy low, sell high, repeat frequently," not unlike a casino.
While the popular understanding of the stock market has evolved in recent decades, the math underlying the stock market has not. The math bears out the instrumental role of stocks and the ultimate point of investing in them: getting a regular, and where possible growing, cash payment over time. On any given day, the number of buyers and sellers and a whole host of factors external to a company itself will set the price of a stock. Determining an actual present value for those securities (i.e., what one might consider a fair price), however, involves calculating the dividend yield (the annual dividend divided by the current price), asserting the growth rate for the dividend, and coming up with an appropriate discount rate for the future income stream to take into account risks to the business and the time value of money. The latter is very important and captures the fact that $1 paid to you today is worth more than a promise to pay $1 one year from now. That is because there is still some risk that you won't get paid in a year, and the very real risk that the $1 paid then will buy less than a current dollar of goods and services.
The dividend discount model (DDM) and discounted cash flow (DCF) programs on your financial calculator and in the first chapter of the dust-covered finance textbook on your bookshelf provide a means of figuring out the present value of those future payments. The basic math is worth reviewing briefly. To determine the present value for a flat dividend stream, say $1 per year, you apply a discount rate to the future payments. Using a discount rate of 7.0% means that the annual stream of $1 payments is worth about $14 right now. In other words, all other things being equal (and they never are), a stock trading with a 7.0% dividend yield ($1 dividend/$14 price) has an assumption built into it that the payment will be made for th
Excerpted from THE STRATEGIC DIVIDEND INVESTOR by DANIEL PERIS. Copyright © 2011 by Daniel Peris. Excerpted by permission of The McGraw-Hill Companies, Inc..
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