Despite investing in profit-making companies, a lot of investors have been complaining that they are not getting the desired returns from the companies that they have invested in.
One of the main reasons is that these companies usually pay very low dividends or no dividends to their investors.
Hence, even though these companies make good profits from their businesses, they are not sharing the profits with their minority investors.
Companies that pay good dividends to their investors imply that the major shareholders of these companies are willing to share their wealth with minority investors.
Given that minority investors have no control over these companies, they have only two sources of returns from their investments, namely dividend returns and capital gains.
If the companies refuse to reward their investors with good dividends, then investors need to make sure that they buy low and sell high in order to get capital gains.
Warren Buffett proposes one concept, which is called the one-dollar premise - for every dollar profit that a company makes, it either pays one dollar dividend to its shareholders or if that dollar is being retained, it needs to bring additional one dollar market value.
Companies with good management will always try to maximize the wealth of their investors.
The following table will show the importance of dividends to an investor.
Assuming you have invested in Company A with an average cost of RM15.
Company A generates earnings per share (EPS) of RM1.00 with price-earnings ratio (PER) of 15 times and pay out 80% of its profits as dividends or dividend per share of RM0.80.
Hence, with the purchase price of RM15, the dividend yield (DY) is 5.3%.
We also assume that Company A has a constant PER of 15 times and dividend payout ratio of 80% for the next 20 years.
Annual growth rate of EPS is 8% based on our country’s average nominal GDP growth rate of 8%.
For the first 10-year period, given that our original cost of investment is fixed at RM15, our dividend yield will be getting higher and higher.
For example, first year DY of 5.3% is computed based on DPS of RM0.80 divided by RM15.
And second year DY of 5.8% is calculated based on DPS of RM0.86 (RM0.80 x 1.08) divided by the same original purchase price of RM15.0.
As the company’s businesses continue to grow and generate higher profits, as long as the company practices a fixed dividend payout policy (our example is based on a fixed dividend payout ratio of 80%), investors’ DY will increase.
At Year 10, given that our purchase price remains the same at RM15, with a DPS of RM1.60, our DY is 10.7% (1.60/15.0).
Thus, the average DY for the first 10-year period is 7.7%.
Coupled with the annual capital gain of 8% (the share price has grown by annual growth rate of 8% from RM15 to RM29.99), investors will generate an annual total returns rate of 15.7% (7.7% + 8%)!
If we keep this stock for another 10-year period, our next 10-year annual total return is 24.7% (16.7% + 8%)!
From here, we can see that if we have invested in good companies that always reward their investors with very high dividend payments, our returns will be huge if we hold it long term.
Normally, consumer-based companies and companies that do not need high capital expenditures will be able to reward shareholders with good dividend payments.
Besides, major shareholders must be willing to share their profits with their investors through good dividend payments.
