WHAT ARE WE LOOKING FOR?
Dividends provide a safety net in turbulent markets. Today we're focusing on something called the dividend payback period, which measures the time it takes for an investor to recoup his or her investment in a dividend stock. We'll use data provided by Dow Theory Forecasts, a weekly financial newsletter published since 1946.
WHAT'S A DIVIDEND PAYBACK PERIOD?
As an example, say you bought a $50 stock that pays $1 in dividends annually. It would take 50 years to recoup your original investment through dividends alone (and you'd still own the stock, of course). That's assuming the dividend doesn't change. But if the dividend grows every year, it will take less than 50 years for the stock to pay back its original price.
How much less? That's where Dow Theory Forecasts comes in. In its May 10 edition, the newsletter examined the projected payback periods of 20 large-cap U.S. dividend stocks that have paid dividends for at least 10 consecutive years.
The payback period is determined by two factors: the current yield, and the projected growth rate of the dividend. The higher the yield, and the faster the dividend is growing, the shorter the payback period.
Remember, the payback period is an estimate. The big assumption is that the dividend will keep growing at the same pace in the future as it has in the past. We've used the 10-year historical dividend growth rate, but the future dividend growth rate could be higher or lower, depending on the earnings trend for each company.
"The key to a quick payback is dividend growth, and the key to dividend growth is rising earnings," says Dow Theory Forecasts, which is published by Horizon Publishing of Hammond, Ind. "The knowledge that a stock's dividend stream is steadily recouping the cost of its purchase might make some investors more willing to buy and hold quality stocks."
Investors shouldn't buy a stock based on the payback period alone, says Charles Carlson, chief executive of Horizon Publishing and author of The Little Book of Big Dividends: A Safe Formula for Guaranteed Returns.
"It's a little bit more of a defensive way to look at a stock," he says. "It's useful for tie-breakers. If you're looking at two stocks and one has a faster payback than the other one, that might be a reason to buy that particular stock."
COMING SOON: CANADIAN PAYBACK PERIODS
Number Cruncher is working on a Canadian version of the dividend payback table. We hope to bring it to you in the next few weeks.