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Mon. Nov. 5, 2007

Dividend Income vs. MMA *

What is the primary reason you invest in dividend stocks? For me, it is a means to build a growing income that can be relied on during retirement. So, why choose dividend stocks instead of another income investment? I view it as an opportunity to see my earnings grow each year, not only from reinvested dividends, but from an increasing dividend rate.

Why would you assume the equity risk and invest in a dividend stock if you could earn a better return in a less risky money market account (MMA)? When I screen for worthy dividend investments, one of my first tests is to determine if the investment will perform better than a MMA over time.

Last week I posted a Stock Analysis on PAYX including a link to a PDF containing a detailed analysis. In this article, I will explore the section titled Dividend Income vs. MMA (located in the top right section of the above linked PDF). This section helps me determine if the investment’s dividend income could possibly pay more than interest earned from a MMA, over time. Below is a description of each item in the Dividend Income vs. MMA section from page 2 of the analysis:

MMA Rate:
Representative high money market rate (MMA) at a financial institution that is insured by the FDIC up to the legal limit ($100,000). Currently using AmTrust direct as a proxy.

NPV MMA Diff.:
The basis of this calculation is a hypothetical $1,000 investment in this stock and a MMA earning the MMA Rate above. The value calculated is the net present value (NPV) of the cumulative differences between the dividend earnings of this investment and the interest income from the MMA over 20 years. Other assumptions include: 1.) dividends grow at the Dividend Growth Rate above, 2.) dividends are reinvested, 3.) share price appreciation is not considered, 4.) interest income is reinvested in the MMA. A Star is added for amounts over a certain amount depending on how long a company has paid a dividend. $10,000 for a company that has paid a dividend for less than 10 years, $7,500 for a company that has paid a dividend from 10-25 years and $2,500 for a company that has paid a dividend for more than 25 years. A Star is deducted if the amount is negative.

Years to >MMA:
The number of years until dividend earnings exceed the earnings from a hypothetical money market account earning the MMA rate above, considering the other assumptions listed in “NPV MMA Diff.” above. A Star is added if the number of years is less than 5.

Considering what AmTrust is currently paying (5.36% APR at the time this article was written), yield’s on most dividend paying stocks are well below that of a high-yield MMA . Thus, my emphasis on over time. As noted in the NPV MMA Diff. description above, my chosen time horizon is 20 years. Given the future uncertaintly, if it takes less than 5 years for the investment’s annual earnings to exceed the MMA’s annual earning (Years to >MMA), a Star is added.

To quickly perform this test, I enter 10 years of dividend payments and the current yield of a stock into my model. Given those inputs, the model will calculate the NPV of the earnings difference on a hypothetical $1,000 investment in the stock and a MMA. If the amount calculated is negative, you would earn more by putting your money in a MMA. Even if the amount is positive, a lot can happen in 20 years, so I look for a $10,000 cushion. This is the level I have elected to add a Star.

Let me point out some potential flaws to my calculation:

  1. I assume a steady interest rate for the MMA over the 20 year period.
  2. Since I am looking at the ability of the investment to generate income, I ignore any share price appreciation.

Due to the great disparity between certain high-yield MMA rates and published rates (http://www.bankrate.com/ today is reporting the national average for MMA is 3.5%), I have chosen to use a rate that I am actually getting. Over time, I will probably normalize the MMA interest rate I use by building an average of the available high-yield MMA rates .

Before I perform the tests above, I check to see if the company has lowered its dividend over the last 10 years.

What is the first thing you look at when evaluating a dividend stock?

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9 Responses to “Dividend Income vs. MMA *”

  1. TheLocoMono says:

    I admit I don’t know much about dividend stocks but ever since I got several shares of dividend stocks as a gift, I have been learning a little bit here and there about dividend stocks. My experience with my stocks has been two fold, splits and constant dividend increases.

    I don’t know how much of a factor splits plays into my observations but with steady dividend increases, it certainly warrants additional investigation into how it can assit me with a long-term strategy.

  2. Dividends4Life says:

    TheLocoMono: Mathematically, splits have no effect on the stock (more shares worth less per share). There is usually a small short-term boost in the stocks price once a split is announced. This highlights the fact the share price has grown and management is confident it shouldn’t fall below their target price. Most companies have a preferred trading range for liquidity purposes.

    Constant dividend increases are a dividend investors best friend. They are the building blocks for a financially secure future.

    Best Wishes,
    D4L

  3. Anonymous says:

    What most of you fail to comprehend is the fact that FDIC is a house of cards. When the Regional Banks begin to fail, FDIC willl go down the tubes. Look at the financial health of the United States and ask yourself the question how can the politicians prevent anything…..our country is broke and doesn’t know it.

  4. Russ Krull says:

    If I read it correctly, your method ignores share price appreciation, but assumes dividends are reinvested. How do you determine the price for reinvesting dividends?

  5. Dividends4Life says:

    Russ: It is done on a dollar basis looking at the yield and yield growth, where price is irrelevant. If you would like to see the model, click on Tools in the menu bar above and download D4L-Prescreen.xls.

    Best Wishes,
    D4L

  6. Anonymous says:

    For your MMA rate which AM Trust rate do you use? The 9Month CD rate that they highlight on the page you link to?

    Excellent site by the way!

  7. Dividends4Life says:

    Anon: I use the highest paying rate of the the 4 MMA that I hold (AmTrust, ING, CapitalOne Emigrant Direct).

    Thanks for stopping by.
    D4L

  8. Mike says:

    Ignoring share price appreciation seems bizarre. You assume dividends will grow at a certain rate and at the same time you assume the price of the stock will be constant? Surely if the dividend actually increases as you expect, the share price will also increase … otherwise the yield available to a new (future) buyer would be extremely high.

  9. Mike: The “share price appreciation is not considered” is not the expected result, but just the most conservative. In my latest D4L-Prescreen.xls model, I run a scenario that assumes share price growth = dividend growth. It produces the highest value.

    Best Wishes,
    D4L