Effective Yield

Every company is faced with a question of whether earnings should be returned to investors (who own the company) to be invested as they wish, or re-invested in the company by management.  Benjamin Graham famously believed that a company should leave this choice with the investor, and companies should return a portion of their earnings to investors.  Some companies truly can deploy capital better than the investor may be able to.  In growth industries, some companies hold very large cash positions and grow earnings through acquisitions.

Whatever your feelings on corporate policy, the fact is dividends have represented over 40% of the total stock market return since 1926.  Capitalizing on dividend payments is more than simply selecting stocks paying very high dividends.  In fact, a stock paying an extremely high yield should set off a red flag to an investor.  Unless it’s a company in an industry that requires a certain payout ratio (like a REIT or MLP), a high yield usually means a company whose share price has recently plummeted and will likely have to suspend or reduce its dividend in the very near future.

As an investor, I look for companies paying out a sustainable yield.  A term I’ve seen bandied about recently is the idea of an “effective yield.”  This refers to companies that have a history of increasing their dividend payments as their earnings grow.  Typically, as dividends and earnings grow, share prices increase as well.  The term effective yield refers, specifically, to the fact that if a company has increased it’s dividend and it’s share price has risen, you’re actually earning a much higher yield on your initial investment than simply meets the eye.

For instance, if you had purchased Abbott Laboratories (ABT) in 1983, it was trading at about 2.82 and yielding 2.21%.  If you simply held the stock through the end of 2009, your ABT stock would be worth $53.99 per share and yielding 2.89%.  This would give you an “effective yield” of 55% ($1.56/share) on your initial investment.  This demonstrates the power of investing in companies committed to increasing their dividends.  Hat tip to Dividend Growth Investor for providing this excellent example.

You could do even better if you reinvested all your dividends in the company.  Many companies offer dividend reinvestment programs at no-cost.  If you’re using the capital being returned to you and reinvesting in the company, you’re increasing the dividend payout each time by owning more shares.  The question you’ll have to ask yourself is whether you think you can earn a better return using the capital in another way.  If the answer to that question is “no”, you might want to ask whether you should be invested in that company at all.

Some people criticize thinking about yield in this way, and say no – your yield is 2.89% because you could simply sell your shares and invest in anything else that you choose – including something that has a higher yield.  I understand this argument, and don’t necessarily disagree, but I like thinking about dividend growth in terms of effective yield.  For one, it’s a tax efficient way of holding and thinking about stocks.  You’d have one heck of a long term capital gain if you sold your ABT stock in favor of, say, the higher yielding ConocoPhillips (COP).  If nothing else, effective yield demonstrates that all those companies paying yields between 1-3% can have more value than meets the eye if they are committed to growing their earnings and correspondingly increasing their dividends on the way up.  ”Buy and hold” investing in long-term, stable growth is still a viable strategy, and examples like this illustrate that.

Of course, just because a company has been paying and/or raising its dividend for the last 100 years doesn’t mean they’ll continue to do so over the next 100.  Economic conditions can change.  If you bought, for instance, Bank of America (BAC) before the financial crisis for its yield and history of increasing its dividend, you probably aren’t too happy right now.  The key is to look for companies that not only pay dividends, but have durable competitive advantages and/or good economic prospects.  I’ll be writing about durable competitive advantages sometime in the near future.  Thanks for reading.

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Tagged as: Abbott Laboratories, Bank of America, Benjamin Graham, competitive advantage, ConocoPhillips, dividend growth, dividend yield, Economics, Effective yield, high yield