A dividend is a share of profits and retained earnings that a company pays out to its shareholders. When a company generates a profit and accumulates retained earnings, those earnings can be either reinvested in the business or paid out to shareholders as a dividend.

Dividends can create a rising source of income for a lifetime. They have proven to grow at twice the rate of inflation over the better part of stock market history.

Dividends are one of three ways for a company to return value of their profits and a portion of its free cash flow to shareholders. The other two ways are for a company to buy back its shares and to re-invest in the company.

It returns cash to shareholders

It reduces the number of shares outstanding.

As a company increase the dividend on a annual basis, the amount may be small, but over time, it can become significant.

For example, if you own stock in a company that pays a dividend of 57 cents per share, they may announce a dividend increase of 4 cents to 61 cents. That means you get and extra 4 cents for each share you own.

Although, it’s only 4 cents, but 4 cents on 57 cents is am7% dividend increase on each share you own. If the dividend increased by this amount, 4 cents, every year, the dividend would double in about 10 years. Thus, over time, if you stick with dividends, the money will begin to grow.

In S&P 500 Index companies alone paid out $485 billion in dividends to shareholders.

Dividends outpace inflation

Back in 1980, a $10,000 investment in the S&P 500 Index paid a dividend of about $421, or 4.21%, on the initial investment. Forty years later, the dividend income had climbed to $5,724, a 57% annual yield on the original investment. And, the original $10K investment grew as well. The original $10K invested in the S&P 500 Index in 1980 would have grown into more than $287K as the stock price increased. That’s not counting the dividends paid.

The price-only-return (which excludes dividends income) is 8.75% per year. If you add in another 3% for the dividends you receive each year, you get a total average return of about 11.75% per year.

Dividends have proven to be a more consistent source of growing income that has outpaced inflation.

Dividends and Total Return over that 40 year period,

Total return is one of the most important concepts in finance, and it involves more than just the dividends a company pays out.

The total return of a stock is the total amount your investment changes in value, calculated by adding the amount of dividend or interest income received to the investment’s capital return (i.e. change in the investment’s price).

Total return is driven by three components: earnings growth (which fuels capital gains and the underlying intrinsic value of a stock), dividends, and changes in valuation multiples.

Dividends have been a major component of the stock market’s overall total returns throughout history and have contributed anywhere from 25% to 75% of the market’s overall total return over the past seven decades (the remaining portion of total return is accounted for by capital gains, or the market’s change in price).

Takeaway, dividends are a powerful wealth building tool. If you invest in perennial dividend payers and consistent dividend grower companies, and then be patient, the dividends will add up significantly over decades.

References:

1. https://corporatefinanceinstitute.com/resources/knowledge/finance/dividend/
2. https://www.wesmoss.com/news/the-power-of-investing-in-dividends-generating-income-from-stock-dividends-vs-bond-interest/
3. https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/paying-back-your-shareholders
4. https://1.simplysafedividends.com/dividends-vs-total-returns/