How Does Inflation Affect Stock Dividends


 

Ask SmallInvy

 

Dear SmallIvy,

I have a bunch of dividend paying stocks I use for current income.  How will inflation affect these dividends?

Thanks,

Chuck

Dear Chuck,

Investors require a certain return (yield), after inflation, for the money they invest in stocks.  In inflationary times they will require higher yields since the amount they actually receive (after inflation) will be less unless the yield from the stock increases to account for the increase in inflation.  For example, a stock paying 3% with no inflation will provide the same return as one paying 8% with 5% inflation.  Because one is effectively locking in a yield when buying a stock, investors may actually require higher yields to account for the risk that inflation may increase further during periods when inflation is increasing (like now). 

The way that investors increase yield from a stock is to buy it at a lower price (assuming the dollar amount of the dividend remains the same).  In other words, they may only be willing to pay $80 for a stock at 5% inflation that they would be willing to pay $100 per share for at 0% inflation if the stocks pays a dividend of $5.00 per share per year.  This means that if you own dividend paying stocks and inflation increases, the price of the stocks will tend to go down.  This will be a temporary thing since eventually the company will start paying a higher cash amount since the dollar amount they will start receiving from their business will be more, therefore allowing a larger cash amount be paid out for a dividend.

If you don’t need the principle of your investments anytime soon, the best thing to do would be to stay put – eventually stock prices will recover and the effective yield you will be getting from the stock will increase.  Also, if inflation doesn’t increase for a long time, you won’t miss out on all of those dividend payments while inflation is low and the stock price remains stable.   If you have some money in cash to invest, however, given the current inflationary climate you may want to hold it off to the side while we see what happens with inflation.  If inflation kicks in, you would then be able to buy stocks or even bonds at high yields and low prices.  You can then lock in a great dividend and hope inflation drops back down to recent levels.  Imagine if you had bought bonds when interest rates were 18% in the 1970’s and then held them when rates fell – you would have a nearly guaranteed return at a rate much greater than the return of the stock market.

If you do need to principle soon, you should probably sell some stock and take the money you need out of the market.  If inflation increases, the near-term effect on stock prices won’t be pretty.

SmallIvy

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