If you’re new to investing, these five concepts should give you a high-level introduction to how to think of money and stock investing.
A dollar today is worth more than a dollar tomorrow
Because of the time value of money, a dollar today is worth more than a dollar tomorrow. $10 could buy a lot more things 30 years ago, because inflation has propped up the prices of goods and services over time. It follows that the earlier you can get cash flows on your investments, the better. This is what makes high-yield and safe dividend stocks so valuable and sought after in most market environments.
A 5% yield versus a 2% yield
By buying dividend stocks that pay out safe and juicy dividends early on, you can start earning stable cash flows sooner. For instance, if you get a 5% dividend yield now across your $100,000 dividend portfolio, you earn $5,000 of income a year. However, if your yield were 2%, your annual income would only be $2,000.
The catch of a 5% yield versus a 2% yield
Oftentimes, a 5% yield portfolio will have slower growth than a 2% yield portfolio. For example, dividend stocks offering a yield of about 2% are expected to grow at likely a double-digit rate versus a 5%-yield stock that’s growing by about 2-5%. Assuming the stocks are fairly valued at your purchase time, your long-term projected annualized returns are at least 12% for the 2%-yield dividend stock and 7-10% for the high-yield stock.
One can also argue that the 2% yield stock is riskier, because no one knows for sure that the high-growth rate can be achieved and especially not so every year for the long haul. That is, in one year, a growth stock can grow 2%, and in the subsequent year, it can grow 15%. And at one point, after the business grows meaningfully larger, its growth rate is expected to drop. Additionally, many factors, like macro factors are uncontrollable by businesses. In other words, high-yield stocks provide safer returns when their dividends are sustainable.
Does business performance dictate stock performance?
Common stocks discussed in this article have long-term performance that depends on the performance of the underlying businesses. A business that increases its profitability over time (assuming no dilution in the stock) should lead to a rising stock price. However, the valuation of a stock you pay affects your investment returns. In other words, paying for a stock at a lower valuation should lead to higher estimated total returns.
Valuation of the investment
What’s your required rate of return? If your required rate of return is 12%, you simply won’t invest in a stock that is expected to return only 10%. That said, you might require a lower rate of return if the stock in question is lower risk, such as Enbridge, which reports highly stable cash flows that support a safe, juicy dividend.
No matter what your required rate of return is, you should examine the valuation of the stock before making a purchase. If you deem the stock to be expensive at the time, it’s probably better to explore other ideas.
