Dividends Don't Lie

Instead of telling you what you already know, that dividends create tremendous value over the long run, I'll simply lay out the numbers, which are more powerful. The true value of dividends can be explained via a simple math problem. Consider the two scenarios:

In Scenario 1, you own $10,000 worth of ABC, which produces a 6% annualized return over five years. After five years, the $10,000 grows to about $13,400.

In Scenario 2, you own $10,000 worth of XYZ, which produces a 6% annualized return over five years. XYZ also yields 3%, which you then subsequently invest back in XYZ. XYZ also increases its dividend by an average of 10% a year. At the end of five years, your investment is worth close to $16,000.

If you run these returns over 15 years, under Scenario 1, your capital grows to $24,000, and under Scenario 2, it grows to nearly $40,000. My numbers may be slightly off because of rounding, but the value of dividends is made glaringly clear in this example.

Now let's add in today's real-world considerations: a zero-percent interest rate environment, inflation and what I would venture to guess will be a negative real rate of return in owning 10-year Treasuries that yield 1.8% today. Also, dividends are great when they can be counted on and don't come at the expense of a declining stock price. But there is also a secret about dividends that most of us know but few act upon: Dividends are real cash payments. You cannot manipulate cash flow like you can earnings per share.

The market seemed to figure out the dividend thing with Wal-Mart ( WMT) back in May, and since then, shares are up nearly 50%. Consider that for the preceding 10-plus years, Wal-Mart shares had been flat, except for the annual dividend. Wal-Mart now yields a decent 2%, but for some time it was sitting there paying out more than 3% a year until investors came charging in.

You may have missed out on Wal-Mart, but there are still some high yield dividends from quality blue-chip-like names that are set to offer respectable equity appreciation as well. The toy company Mattel ( MAT) currently yields 3.5%. The interesting thing about Mattel is that aside from the share-price volatility during the recession, shares just slowly grew over time. For the past decade, the company's average return on equity has exceeded 20%. Operating margins are in the high teens. Now for the best part: In 2002, the dividend payout was $0.05 a share; in 2011 Mattel was paying out $0.92 a share.

Had you bought this company during the 2008 low price of $10, the then-$0.75 dividend was a yield of over 7%. Today you would be collecting a yield of nearly 10% a year and sitting on a gain of around 200%. You won't get anything like that going forward, but you will get a growing dividend from the largest toy company in the U.S. As long as there are children, birthdays and Christmas, Mattel will be just fine.

H.J. Heinz ( HNZ) is another solid dividend play today. It yields 3.6%, and that makes it the highest-yielding big-cap food company stock. You can rest assured the dividend is not going away, since products such as ketchup, soup and Worcestershire sauce generate the cash flow. And given how valuable dividends are today, the stock price will get tremendous support if it starts to slip.

I'm also keeping a close eye on Dell ( DELL), since the shares continue to slide lower and lower, in the process creating a 3.3% yield. The dividend is new for Dell, so I'd bet the company has no intention of taking it away. In fact, seeing as how founder and CEO Michael Dell has bought $500 million worth of shares for himself, he has every incentive to boost the payout.

Dividend-paying stocks are cash-flow-producing companies. In the long run, value is created by cash-flow growth, and the perennial dividend-paying companies have demonstrated that they can generate cash flow and pay dividends in any environment.

At the time of publication, Gad had no positions in stocks mentioned, although positions may change at any time.

Sham Gad is the managing partner of Gad Capital Management, a value-focused investment firm based in Athens, Ga. Gad has written extensively for The Motley Fool and was a securities analyst for UAS Asset Management, a small value investment fund in New York City, in 2007. From 2002-2005, Gad managed assets for the Gad Investment Group.

Additionally, Gad has just released a new book, The Business of Value Investing: Six Essential Elements to Buying Companies Like Warren Buffett. He earned his BBA and MBA at the University of Georgia. Gad appreciates your feedback; click here to send him an email.

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