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Dividends Are A Return Of Capital And A Return On Capital

June 10, 2014

I often espouse the benefits of investing in companies that regularly pay and raise dividends. Of course, there are a number of reasons I do so, and I try to share these reasons as much as possible.

Today I’m going to show you how dividends reduce risk by functioning as both a return of capital and a return on capital.

There’s a difference between the two, but how does that work?

A return on your capital is simply a return on investment (ROI). You invest money in something that produces a return, and that return is your ROI. It doesn’t matter if this investment produces income or simply appreciates in price. Let’s say you buy a stock that pays no dividend:

You pay $1,000 for 10 shares of ABC Company at $100 per share. A year later you sell your 10 shares for $1,200. I’m going to leave out taxes and commissions for the sake of simplicity. So the $200 profit from the sale is your ROI. That’s a 20% return over the course of one year, which isn’t bad at all. Repeat that over and over again and you should do well.

Now, that scenario worked out pretty well. You likely had to stomach some ups and downs in the meanwhile, but all of your initial capital was returned to you, with a nice profit to boot.

But what happens when that asset doesn’t appreciate?

Let’s say you bought those same 10 shares ($100 per share) of ABC Company for $1,000, but a year later the company announced something Mr. Market didn’t like and those same 10 shares are now worth only $800. You decide to sell on the news as the fundamentals have changed and you net a ($200) loss on your investment. So you just took a 20% haircut, meaning your ROI is -20%. You not only didn’t receive a profit, but you also took a loss on some of your capital. The capital you now have to reinvest elsewhere is smaller.

Dividends Act As A Buffer

Stocks that do not pay any dividends means your returns are completely at the mercy of Mr. Market. I like to say dividends act as a kind of “buffer” between the market and your capital, and that’s because dividends flow directly from a company to you as a shareholder. They bypass the stock market altogether, and so that’s why you’ve got this interesting relationship going on where they function as both ROI, but also a return of your capital.

When you invest in a company that pays a dividend (even better if they raise it regularly) you’re receiving capital directly from the company. No matter what happens to the company’s stock price, that company is sending you money back. Slowly the capital you initially invested with the company is being directly returned to you in the form of regular dividend payments. So the share price may oscillate wildly affecting the eventual outcome of your ROI (if you ever sell), but your risk is being reduced one dividend check at a time because the capital you initially invested is slowly being returned to you. Eventually, if you hold on to the investment long enough and the company continues to pay dividends during that time frame, all of your capital will be returned to you, meaning any share price appreciation comes with essentially no risk on your part.

Even while dividends do affect your total return as they’re added on to any capital gains you may or may not receive, they also function as a return of your capital as a company you buy shares in sends you regular dividend payments.

So let’s get back to that earlier example, using the first scenario. This time, ABC Company pays a $3.00/year dividend per share (3% yield).

In the first circumstance, you seen the share price appreciate from $100 to $120, but now you also collected $3.00 per share in the form of a dividend. So your ROI was boosted slightly to 23% – 20% from capital gains and 3% from the dividend. In this scenario, you collected $3.00 per share directly from the company and $20.00 per share in capital gains. So not only are you left with $1,230 when all is said and done in terms of your total return, but the $30 you received directly from the company means the capital you had at risk, even if the company went bankrupt, is only $970.

Do you see how that worked?

Real-Life Example

If you didn’t understand quite how that worked, I’m going to use a real-life example to illustrate my point. And I use this example because I work better with real, working models. Hypothetical examples are nice, but anyone can massage numbers to make their point.

Philip Morris International Inc. (PM) is the second largest investment in my personal portfolio.

I accumulated shares in this tobacco giant over the course of three years, starting in January 2011 and my latest purchase coming in January 2014.

I’m including a screenshot directly from my Scottrade account so you can see accumulation in action:

PM

I spent $7,927.55 of my own capital in my accumulation of 100 shares.

Of course, it’s wonderful news that these shares are currently worth $10,147.02 (as of this writing).

But you know what’s even better?

I’ve received a total of $860.25 in dividends during my ownership tenure.

That means my return on capital is boosted, as the total return on my capital isn’t calculated from the difference between $10,147.02 (current position value) and $7,927.55 (cost basis) – which would be 28%. Rather, my total return is calculated from the difference between $11,007.27 ($860.25 + $10,147.02) and $7,927.55 – which would be 38.8%. So my ROI is higher than it might look on paper due to the dividends I’ve received over the last three years.

But there is also a return of my capital.

See, no matter what happens to Philip Morris from here the capital I have at risk right now is only $7,067.30, and that’s because Philip Morris has sent me checks that total up $860.25. It doesn’t matter what Mr. Market might think of the company and its future prospects, the business itself has sent me capital. Eventually, if I hold the position long enough and they continue paying dividends, Philip Morris will send me so many dividend checks that they will add up to more than I initially invested in the company. At that point, my capital on the line is essentially $0. The company could go completely bankrupt at that point, and I still would have technically lost nothing. In fact, it’s quite possible with a business that pays you dividends long enough that even if it goes bankrupt and you hold all the way through bankruptcy (an unlikely scenario) you would still actually end up with a positive return. Imagine that!

Conclusion

This is a fantastic aspect of dividend growth investing that is rarely discussed, as I truly believe that dividends reduce risk as they function as both a return on capital (your ROI) and a return of capital (leaving less capital on the table). This allows you to slowly reduce your original capital’s exposure to Mr. Market’s madness, and over time could possibly leave you with none of your capital at risk, even while assets continues to churn out regular dividend payments to you while the equity ownership shares continue to also appreciate in value.

Of course, there are detractors to this belief as they may point out that any dividends that do not leave the company’s coffers could potentially leave the company in a better financial position and that capital could be invested elsewhere, propelling the share price by an equal amount. But I don’t invest for coulda, shoulda, woulda. I invest for real-life cash flow. And my Philip Morris example shows you not only how dividends can boost return on capital, but also return your original capital back to you in small pieces, essentially reducing your risk (via capital exposure) with every passing payment.

How about you? Do you believe dividends reduce risk in this way?

Thanks for reading.

About the author:

Dividend Mantra
Trying to retire by 40 by investing in dividend growth stocks and living frugally, valuing time over money.

Visit Dividend Mantra's Website


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Comments

batbeer2
Batbeer2 premium member - 3 months ago

Hi Dividend Mantra,

You say:

.... dividends flow directly from a company to you as a shareholder. They bypass the stock market altogether, and so that’s why you’ve got this interesting relationship going on where they function as both ROI, but also a return of your capital.

This is not true.

As a shareholder, you own the excess cash of the company. Transferring it from the coffers of the company to your bank account doesn't increase your wealth. Before the transfer, the CEO had an obligation to redeploy the cash on your behalf. After the transfer, the CEO is relieved of this obligation.

So, the act of transferring the cash is in fact neither a return on capital or of capital. If the dividend is paid from excess cash, this means the CEO did something right a while ago. Your wealth had already increased before the dividend was paid.

Case in point: DJCO.

Management deployed some cash and the shares of the company are now worth more than they were was a couple of years ago. They represent a greater share of the world's wealth regardless of the price mr. Market is willing to pay. While most investors have an emotional need for a dividend (or for that matter a higher bid by mr. Market) to prove they're richer, it is not rational (I'll admit it is human).

This is not to say dividends are bad. In fact a good CEO should return all excess cash in the absence of opportunities for profitable investment. This is what Michael Dell (Trades, Portfolio) should have done and didn't. In my view he's one of the worst.

You say: but your risk is being reduced one dividend check at a time because the capital you initially invested is slowly being returned to you.

And then what?

You spend the cash on a nice box of chocolates? You buy another stock?

If your goal in life is to eat chocolate, then by al means use the cash to buy chocolates and reduce the chance of not achieving your goal to zero.

If however you are a net buyer of stocks, then you are merely redeploying the cash in a different (or maybe the same) stock. Unless you are a much better capital allocator than the CEO of the company you own, you are adding risk. You have paid taxes and you are less wealthy than you otherwise would have been. You are moving away from your goal.

In other words, most people feel safer if they're at the wheel even if there is a superior driver available. This doesn't change the fact that they are assuming unnecessary risk.

FWIW, I think you deserve to control more capital because of your parsimonious lifestyle and rational capital allocation.... in time you will. Still, I think it is important to understand that dividends are not neccesarily a good thing (or for that matter a bad thing). They are good or bad depending on the context.

For the net buyer of stocks, they are a drag.

jtdaniel
Jtdaniel premium member - 3 months ago

Batbeer2,

Awesome analysis and explanation. Although I could not explain it so well, this is why I hold Waters, Bio-Reference Labs and Berkshire, despite their no dividend policies. I think Dividend Mantra's objective is to pay living expenses from dividends, so naturally this calls for a different approach.

Dividend Mantra
Dividend Mantra premium member - 3 months ago

Batbeer2,

"This is not true.

As a shareholder, you own the excess cash of the company. Transferring it from the coffers of the company to your bank account doesn't increase your wealth."

This statement of yours has nothing to do with the statement of mine you were referring to. I was discussing how dividends bypass the stock market, and flow directly from the company to the shareholder. You seem to agree with this in "transferring it from the coffers..." so I'm not quite sure where you're going.

As far as the usefulness and attractiveness of dividends themselves, this has been discussed ad nauseam. Share buybacks can be easily manipulated for executive compensation, while spending the cash may or may not lead to returns in excess of what a shareholder could acheive with the same cash. If you're saying most people are better off if someone else controls their money, I think you're making an awfully aggressive blanket statement.

If you controlled Coca-Cola's board of directors and decided to suspend the dividend right now, where are you going with the $5 billion to acheive superior ROE? How do you know you could do something better with the $5 billion than all the shareholders every single year?

Best wishes.

batbeer2
Batbeer2 premium member - 3 months ago

Hi Dividend Mantra,

You say: This statement of yours has nothing to do with the statement of mine you were referring to.

What I am referring to is "dividends flow directly from a company to you as a shareholder".

As framed, it is not true. The dividend does not flow to the shareholder because it was his to begin with.

If you feel the cash is at risk when it is in the hands of the CEO of a company you own, then maybe you shouldn't be owning that company. What's more, if you think cash is perfecty safe in your bank account then I guess you're not married ;o)

- Or have an account on Cyprus.

- Or the amount of cash you have doesn't exceed the guaranteed limit (yet).

As for Coca-cola and management not knowing if they can do better or worse than the individual shareholders..... that's simple. If you feel the CEO of a company you own is a worse capital allocator than you but is hoarding cash (or other assets) you should either replace the guy (what Buffett did with Berkshire) or sell. Don't be too arrogant though. While I have criticised the actions of the BoD of KO, I'm ready to admit I couldn't do a better job myself. Also, I didn't say dividends were bad. In the case of KO I think it is probably the right policy. KO is a good company that pays a dividend but they are not good because they pay a dividend. I have seen terrible companies pay a decent dividend. It ends in disaster. AIG comes to mind.

You say: If you're saying most people are better off if someone else controls their money, I think you're making an awfully aggressive blanket statement.

Fair enough. What's more I believe many people who would be better off if they let others control their money, will not admit to it. To me, this is an opportunity. Any time I trade, I'm a predator. Aren't you?

I haven't reported my missing credit card to the police because whoever stole it is spending less than my wife. - Ilie Nastase

jtdaniel
Jtdaniel premium member - 3 months ago

Hi Dividend Mantra,

I understand Batbeer2's main point to be that the shareholders own the earnings at the time they accrue. Each shareholder in turn owns their proportionate share of each year's after tax profits. Investors with this mindset would not see the board of Coca-Cola as benevolent in paying and raising dividends. Rather, they would expect the board/CEO to allocate these funds in the interest of the share owners. If KO was now trading at 12 times earnings instead of 20, a massive share buy back would be perfectly rational. Same for right-priced acquisitions. Would PepsiCo have done its shareholders any favor in 1965 by passing on Frito-Lay to pay a higher dividend? I think of great growth stocks like McDonald's in the 1960s and 1970s. Good thing for shareholders that Ray Krok invested in growth all those years.

batbeer2
Batbeer2 premium member - 3 months ago

@Jtdaniel

Yes

LwC
LwC - 3 months ago

Dividend Mantra,

FWIW IMO your POV about the usefulness of dividends when seen as a return of capital is a valid one. Indeed many other investors, both famous and not famous, have articulated a similar view at various times. Also I see that you acknowledge that yours is not the only valid approach; rather you are simply advocating your own approach by describing the results you've obtained by formulating a long term investment strategy and acting on it in a consistent manner over time.

As another illustration in support of your approach, IMO BRK's holding of KO is an interesting example.

BRK has held most of its KO shares for more than 25 years. According to Andrew Kilpatrick in Of Permanent Value, BRK paid about $1.3 Billion for its KO shares. BRK currently owns 400 million split adjusted shares and AFAIK that represents pretty much all the original shares purchased (if anyone knows if BRK purchased a material additional amount shares since about 1990 or so, please speak up.) So on a split adjusted basis, BRK paid about $3.25 per share.

KO is currently paying an estimated $1.22 per share dividend, so BRK will receive almost $500 million in dividends this year. That represents about 38% of its cost basis. So BRK is receiving its total original investment back every three years at current dividend rates. Clearly BRK has received back several times its original investment in dividends over its holding period, and the shares have a current market value about 10 times its cost. And KO has done this while pursuing additional new business investment, buying back shares, and paying regular and increasing dividends. Even if KO shares suddenly went to zero today, BRK will have received back its original capital and will have made a tidy profit on its investment from the dividends it has received.

I guess one could argue that if KO hadn't paid dividends for the better part of a century, it would have a vastly better and larger business by reinvesting the many billions of dollars it instead paid out in dividends, but in reality there's no way to know that.

"But I don’t invest for coulda, shoulda, woulda. I invest for real-life cash flow."

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