Owning shares in companies that distribute their earnings as dividends can be a great source of passive income. But can dividend stocks make me rich?
According to billionaire investor Warren Buffett, this is complicated. Here’s what the Berkshire Hathaway CEO has to say on the subject:
We don’t get rich on our dividends that we receive, although we’re happy to receive them. We get rich on the fact that the retained earnings are used to build new earning power, repurchase shares, which increases your ownership in the company and Berkshire has retained earnings since we started. That’s the only reason Berkshire is worth a lot more—it’s that we retain earnings.
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According to Buffett, it is possible to build wealth by investing in dividend shares. But it’s not the dividends that the companies pay out that make this happen — it’s the earnings they retain.
Share buybacks
One of the reasons why Buffett thinks retaining earnings is important is that it allows companies to repurchase their shares. This is important. Buying back shares reduces the number of outstanding shares. In doing so, it increases the amount of the business that each share is worth.
If a company has 100 shares outstanding, then each one is worth 1% of the business. If it repurchases five of them, then each remaining share is worth 1.05%.
Following Buffett’s approach, both of the stocks that I have my eye on use their earnings to repurchase shares as well as distributing cash as dividends.
Bank of America
One of the best illustrations of this in action is Bank of America. This is the second largest investment in the Berkshire Hathaway stocks portfolio. Bank of America has distributed $8.4bn in dividends this year. At today’s prices that’s a yield of 2.44%.
Importantly, the company has also spent around $11.6bn on share buybacks. In doing so, it has cut its outstanding share count by 3.9%.
Rightmove
That brings me to a UK stock that I think has similar features. The stock is Rightmove (LSE:RMV). Over the last 12 months, the property website paid out £67m in dividends. At today’s prices, that’s a 1.44% dividend yield.
The dividend allows me to increase the number of shares I own. But the company has also spent £146m on share buybacks. As a result, the number of shares outstanding has declined by around 3%. That means the amount of the company for which each of my shares accounts is higher than it was a year ago.
Dividend stocks
I’m looking to add to my investment in Rightmove by buying more shares at today’s prices. I think this is a dividend stock that fits the criteria Buffett looks for to build wealth.
Rightmove shares offer a double boost for investors. The dividend allows me to increase the number of shares I own and the retained earnings being used for buybacks boost the value of each share.
But the stock isn’t without risk. Most obviously, a slowing housing market might well challenge the company’s growth.
In my view though, this is a risk work taking. A strong business that uses its earnings to drive shareholder returns is one I’m happy to own in my portfolio.
