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The two best ways to maximise dividend income

In his 2022 Berkshire Hathaway shareholder letter, Warren Buffett discussed the ‘secret sauce’ to investing, highlighting growing dividends at two of his long-term holdings: Coca-Cola (NYSE:KO) and American Express (NYSE:AXP).

Berkshire bought shares of Coke for a total cost of US$1.3 billion in 1994. The cash dividend that Berkshire received from Coke in that year was $75 million. By 2022, the Coke dividend paid to Berkshire was US$704 million.

Of this, Buffett said: “Growth occurred every year, just as certain as birthdays. All [business partner Charlie Munger] and I were required to do was cash Coke’s quarterly dividend checks. We expect that those checks are highly likely to grow.”

American Express has been a similar story. Berkshire completed the purchase of the company’s shares in 1995, also for US$1.3 billion. Annual dividends from Amex grew from US$41 million then to US$302 million in 2022.

The dividend growth from these companies has been incredible for both Berkshire and Buffett. The dividend from Coke grew 9.4x over the 28 years to 2022, at a compound annual growth rate (CAGR) of 8.3% per annum (p.a.).

The 2022 dividend from Coke represented an annual yield of 54% on Buffett’s original purchase price (it’s now 60%). In other words, for every dollar that Buffett invested in the company, he’s now getting 60 cents in annual dividends. In total, he’s received US$10.72 billion in dividend income, against a cost of US1.3 billion, and he’s used that dividend money to buy stakes in other businesses and shares through the years.

Likewise, American Express grew dividends by 7.4x over 27 years, at a CAGR of 7.7%. Buffett is now getting an annual dividend yield of 23% on his original purchase price.

The wrong conclusion to draw from this is that Buffett bought these companies for their dividends. He didn’t. Amazingly, Coke did offer close to a 6% yield in 1994 because Buffett bought it on the cheap. By contrast, his purchase of America Express was when the stock was on a yield of about 3.2%.

But Buffett purchased Coke and American Express because of their ability to grow earnings over the long term. The dividends were merely a by-product of the earnings growth. Without the earnings power of the companies, dividends wouldn’t have been able to increase at the clip they did.

Earnings drive dividends

An example can illustrate the point. Let’s take a stock called ‘Good Dividend Yield Corp’. The business has $100 dollars in equity, and it makes a reasonable return on that equity of 10%, resulting in $10 worth of profit. Of that profit, it pays out 50% as a dividend, equivalent to $5. It retains the remaining $5 in earnings for reinvestment in the business.

I buy this stock for $100. That equates to a price-to-earnings (PE) ratio of 10x and a dividend yield of 5%.

By year 20, the company has increased profits to $26.50 from $10. Dividends are up from $5 to $13.30, at a CAGR of 5%. By year 20, the annual dividend yield at cost for the business is 13.3%.

If the shares trade at a similar PE ratio of 10x, they would be worth $265.50 in year 20. That would equate to a share price return of 5% p.a. ex-dividends. Not too bad.

Let’s now look at another company called ‘Faster Growing Corp’. This business has $100 in shareholders equity but earns a better return on equity of 18%, resulting in net profit of $18. Of that profit, it pays out 50% as dividends, equating to $9. It retains the remaining $9 in earnings for reinvestment in the business.

I buy this stock for $350. That puts it on a PE ratio of 19.4x – not cheap but probably fair given the growth in the company. The dividend yield is 2.6%, lower than I’d like.

By the end of year 20, ‘Faster Growing Corp’ has increased profits to $101 from $18, up 5.6x, at a CAGR of 9%. Dividends have followed suit, growing from $9 to $50.40 over the same period, also a 9% CAGR.

By year 20, the annual dividend yield at cost for the business is 14.4%. In other words, though ‘Faster Growing Corp’ had a dividend yield about half that of ‘Good Dividend Yield Corp’ in year 0, the yield at cost for the former had risen to more than latter by year 20.

That’s not the full story, though. If we assume the same PE ratio for ‘Company B’ of 19.4x at year 20, the stock price would be $1,941, up from $350 at initial purchase, equivalent to a return of 9% p.a. ex-dividends.

By the end of year 20, ‘Company B’ has a higher dividend yield at cost, a faster growing dividend, all the while having achieved a higher total return over the preceding period.

The lesson is that earnings drive dividends. You want to own businesses that can grow earnings over the long term and pay out a portion of those growing earnings as dividends over time. By doing this, you stand a chance of being in the enviable position that Buffett is with Coke and American Express.

Another way to maximise dividend income

The other overlooked aspect of dividend investing is the importance of reinvesting dividends.

Now, the great Warren Buffett doesn’t reinvest the dividends from his stock holdings. That’s because he takes that money to invest in other businesses which he thinks can offer even better returns.

I’d suggest that you don’t follow Buffett’s example here. Buffett is an exceptional investor and that’s why he does what he does.

For mere mortals, if you find a good company that can sustainably grow earnings and dividends over time, it’s best to reinvest the dividends. That way, you get to fully enjoy the fruits of compounding returns from the business.

Of course, it’s not always possible to reinvest all cash dividends. Some investors are on high tax rates that can cut into dividends. Others must take dividends out for everyday expenses.

Like everything, much depends on your personal circumstances. As a general rule, though, reinvesting dividends in a great business is a sound long-term strategy.

 

James Gruber is Editor of Firstlinks.

 

17 Comments
Robert
February 17, 2025

Buffet is holding a lot of cash because he has been through many boom/bust cycles, he knows where we are in the cycle now (peering into the abyse). He makes money when buying low, hence the need for cash.

Jim McMahon
February 16, 2025

Seems from the comments that many people just want to grow their wealth for the sake of it. Perhaps trying travelling and living more, giving the homeless person you walk a $10 or $20, attend and support the arts, be more philanthropic and support medical research in your will.

Kevin
February 17, 2025

I agree with you apart from one thing,growing .There is nothing at all I can do to stop it growing,or falling. If it doubles over the next 10 years then it is more millions to donate. Whether I own things or not,that is going to happen..The rest,been there done that got the T shirt. They've made it more complicated to travel.An ETA to get into the UK ,an ETIAS to get into Europe. Asian countries will follow that,the dreaded words,apply online it is much simpler and faster..No more fingerprints and photo at the destination airport.I'm expecting the day when it will be sorry,we can't let you leave Australia,you haven't filled the forms in correctly.

Rikardo
February 16, 2025

Income earning real estate does much the same IMO and I invest in both.

AlanB
February 15, 2025

"You want to own businesses that can grow earnings over the long term and pay out a portion of those growing earnings as dividends over time."
Ahh yes, but which ones are they?
I live off sustainable, growing reliable dividends. They pay my bills.
I'm not very good at predicting what capital growth or the share price of a any particular company will be in year X.

Kevin
February 16, 2025

Nobody can predict,you go with probability.Nobody will admit they are wrong.I can quickly see how wrong I was if I ever look at a stock price.Two simple things CBA price and the NAB price.From the day I bought them I compound at 12%,a mix of dividends reinvested and share price growth.An above average return for a long period of time and you cannot lose. The companies have to survive and you can sell at any time.Most companies don't survive,or they have a long history of doing nothing.

The turn of the century is a good time to start..CBA and NAB at $25 each,or $24 each it all depends on the day you bought them. Every bit of maths will be wrong,it's a matter of how wrong .After 30 years then on one day and one day only see how wrong you were,see how you calculated the number of shares you have wrongly.See how you you got the share price wrong.Have a laugh at the people that calculate everything precisely wrong.

On 30/6/2030 you'll know how many shares you have,and what the price is,then laugh. The next day you're wrong.The share price has changed.All that happened over that 30 years is people that will never own 1 share in either of those companies will tell you you are wrong They didn't buy any shares in that company,so they are right,and you are wrong.Now we have the internet they can search all over the world for validation in what they want to see and believe.

Do the same for ANZ and WBC to choose the two other banks.Same result,wait until 2030.From memory they were around $10 each at the turn of the century..Every day of that 30 years is the same. "We" the crowd didn't buy them,"you"must be wrong. Then on the 30/6/ 2030 they will still deny the last 30 years of history,the rubbish they are going to delude themselves with will be amazing

michael
February 14, 2025

Forgot to mention, a well written, easily understood article. Thanks.

michael
February 14, 2025

Strange to use Buffett as an exemplar. Berkshire Hathaway refuses to pay dividends.

John Storey
February 14, 2025

Buffett refuses to pay dividends because he is able to grow investor's funds at a rate greater than dividend yield.

Refer to his owner manager principles.

A dollar in hands of Buffett is far more valuable than it is in the hands of an investors.

michael
February 14, 2025

The story is about how to grow dividends, because dividends are useful to the recipient. Buffett hands none out to his shareholders.
BH returns have not been stellar recently, & it has held a lot of cash for a long time. How valuable is that?
What use is a share that rises in value every year, until you die, yet never pays a dividend?

"A dollar in hands of Buffett is far more valuable than it is in the hands of an investors."
I think different shareholders will have different opinions at different times.
I suspect the real answer lies in the USA tax system, but don't understand it well enough.

Kevin
February 15, 2025

Once again I cannot understand why people cannot understand compounding,or why they want to make things complicated . Buffett reinvested the dividends for you,if he had paid out dividends what would you have done with the cash to do better than that?.Long term ~ $15 a share in the mid 1960s,he has compounded that for you so one share is whatever they are now, $700 K ? If you want to take money out as "dividends" convert an "A" class share into 1500 "B" class shares .Sell 50 shares a year in one hit ,weekly ,monthly,whatever you want . There is your income ( dividends ) for the next 30 years,you still get to partake in the growth of BRK for the next 30 years.

Closer to home two companies I own,Wesfarmers and CommBank .You can compare the pair as they say . $1000 on the WES IPO got you 1,000 shares,in 1984. Reinvesting the dividends you now have around $1.3 million worth of shares in WES.What would you have done with the dividends if you hadn't used the DRP.?
CBA, $6K to buy 1,000 in 1991.Reinvest the dividends and on payment of the dividends at the end of March you'll have around 7,000 shares in CBA. What would you have spent the dividends on? Far better to reinvest the dividends in a good company,then retire and live off the dividends.

If you can grasp the sheer simplicity of compounding it is almost impossible not to be a rich old person. As Tom Petty sings "The waiting " ( is the hardest part)

Paul Muscroft
February 14, 2025

I am not really blown away by these numbers. I'll admit I am using copilot to get my numbers but in 1995 the US M2 money supply was $3.6T - and the most recent number is $21.54T - so growing at around 6.4% a year. AMEX did a tiny bit better than that and Coke did 3% better (but take into account tax - blah blah). Sure, if all you want to do is track M2 then fine.

Jeff
February 14, 2025

These numbers are only the dividend growth, and do not include capital growth, which for AMEX has been over 3000% during that time (so another 12% p.a. compounded).

Steve
February 14, 2025

I have always viewed ROE as a more robust indicator than dividend yield. Dividend yield is based on the pay-out ratio which is at the whim of directors. Return on equity gives a better understanding of management skill. Unfortunately, most people looking for income are focused on the dividend yield. It pays to go behind the veil and see if ROE will support the higher dividend. Too often, dividend yield is taken as a surrogate for interest yield and yet there is a lot of difference between the two as your examples highlight.

MK
February 13, 2025

Something similar with CBA which floated at $5.40.
The interim dividend is $2.25 this year.

Luke
February 13, 2025

James, your example reminds me of SOL (9% eps and dps growth, 2.8% div yield), CSL and other lower div yield stocks v the big banks or other recognised higher dividend payers. If ppl can go without the higher dividend payers and manage cashflow in the short term they will be rewarded long term through stocks like SOL with a lot higher capital growth and dps growth.

Disgruntled
February 14, 2025

That's the same as saying, if people worked longer they wouldn't need as much money to retire later.

Some want to retire early, just as some want the dividends now to pay for that retirement.

People have different desires in life.

 

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