Imagine you bought a vending machine for $2,000.  This vending machine made you profits of $100 a year, after all expenses.  It would take 20 years to recoup your initial investment.

The amount of time an investment requires to pay back your initial investment amount is called the payback period.

Analyzing investments through the lens of the payback period is very practical.  It tells you how quickly an investment will pay back the amount you put into it.  This makes comparing different investment options very easy.

Keep in mind that the payback period does not take into consideration the gains from the sale of a stock.  It only considers the income produced from your investment, not the return of your initial invested amount.

Valuing a stock perfectly is an impossible task.  Instead of looking for ‘undervalued securities' everywhere, what would happen if we focused on how long it takes for our investments to pay as back?

What would happen if we applied the payback period principle to dividend stocks?

When to Use the Payback Period

Not all stocks have a policy of paying steady or increasing dividends every year.  The payback period is useless for these stocks.

But that doesn't mean it is useless for all stocks.  Some stocks do pay steady or increasing dividends every year, and are very likely to continue to do so.

The payback period can be applied to high quality dividend growth stocks to compare their relative investment merits.

What Is Needed To Calculate the Payback Period?

To calculate the payback period for a dividend stock, you only need 3 pieces of information:

Have you heard the expression garbage in, garbage out?  If your formula uses many uncertain-at-best estimates, the output of the formula is garbage.  You can't get anything of value from valueless inputs.

Of these 3 metrics, 2 of them are exact.  The stock price and the annual dividend payment are not up for debate.  They are what they are.