This is a guest post written by a new dividend investor blogger; Frank @ Dividend Engineering. You guessed it, as many DYI investors he is an engineer ;-).

 

 

To paraphrase John William Burr, one of the founding fathers of stock valuation, a stock is worth what you can get out of it. This simple principle applies completely to dividend investing. In fact, it is probably the basic principle of dividend investing. We, as dividend investors, buy dividend stocks to receive regular and growing payments. So, the more we get out of a stock, the better.

 

Keeping the foregoing principle in mind, it generally follows that we would prefer getting the most out of a stock as soon as possible. Indeed, all else being equal (I know, this is rarely the case), I prefer to receive more money now than later. And there are several reasons for that.

 

First, if we forgo current payment for future growth, the future growth must be interesting enough for us to wait. However, the longer we project dividend growth into the future, the less reliable our projections are. Projecting dividend growth with some measure of accuracy 5 years in the future in already difficult, projecting dividend growth 10 years or even 20 years in future is downright impossible.

 

Second, the higher the dividend growth, the less likely the growth will be sustainable over the long term. Understandably, a company can grow its dividend 15% per year for a couple of years. However, it would be difficult for that company to grow its dividend 15% per year for 10, 20 years. I know that some companies manage to do it but finding such companies before they do it is harder than it seems.

 

Third, the faster we receive the most out of a stock, in other words, the higher the yield, the faster we can reinvest our dividends into additional shares of dividend stocks. In turn, these additional shares will pay dividends which we can again reinvest into further additional shares. And so on and so forth. Understandably, the high yield must be sustainable.

 

So, in order to get the most out of a stock, is higher yield with lower growth better than lower yield with higher growth?

 

As an engineer, I like to play with numbers. So, to answer my question, I have tested three different stocks with different yields and different growths.

 

Stock 1 has a current yield of 1% and a dividend growth of 15%. Stock 2 has a current yield of 3% and a dividend growth of 10%. Finally, stock 3 has a current yield of 5% and a dividend growth of 5%.

 

In the following analysis, I have assumed an initial investment of 10 000$ in each stock. I have also assumed that the dividends are reinvested in the same stock and that the price of the stock grows at the same rate as the dividend such that the current yield stays the same. I have also assumed that the dividends are reinvested once a year. I know, except for the initial investments, the above assumptions are only what they are, assumptions. However, I think they fairly correspond to the reality, at least enough to answer my question.

 

The graph below illustrates the accumulated dividends of each of the three stocks over a period of 20 years.

 

evolution of accumulated dividends

As can be seen from the graph, over the 20 year period, stock 3, the stock with high yield and low growth, always returns more money than either stock 1 or stock 2. Looking at the trend though, stock 2 seems to be catching up. However, stock 1, the stock with low yield and high growth, is significantly far behind both stock 1 and stock 2.

 

In more concrete terms, after 20 years, stock 3, with its high yield and low growth, will have returned shy of 29 000$ in dividends. Following close behind, stock 2 will have returned almost 25 000$ in dividends after 20 years. However, far behind, stock 1, with its low yield and high growth, will have returned only slightly less than 12 000$.

 

Hence, from the graph, it seems pretty clear that stocks having higher yield, even with lower growth, will return much more money to their happy shareholders than stocks having lower yield, even with high growth. It seems to be caused by the fact the high yielding stocks allow you to compound more money, even if at lower rate. In any case, I don’t know for you, but I prefer to have 29 000$ in my pockets than only 12 000$.

 

Finally, the graph above assumes constant growth. However, as mentioned at the beginning, it is harder for a company to constantly raise its dividend at 15% than at 5%, the more so over long periods of time. Hence, if, for instance, stock 1 cannot sustain its annual dividend growth of 15% and must lower it at 10% 10 years down the road, then the above results will be even worse for stock 1.

 

So, if the high yield is sustainable and properly covered by earnings and free cash flow, I think it is better to invest in higher yield stocks, even if the growth is on the low side, than to invest in low yield stocks having higher though probably unsustainable growth.

 

As the say goes: “A bird in the hand is worth two in the bush.” I think it applies to dividend investing.

 

 

 

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16 Comments   |  

16 Comments

Max
January 14, 2013, 7:48 am

Very good. Now adjust for tax and see what happens. Just asking as tax is paid put constantly on dividends therefore lowering the return appreciably.

Mike
January 14, 2013, 7:54 am

Hey Max,

it is true that tax will hurt dividend payouts but I think there are enough space in tax sheltered accounts that you can use dividend investing to your benefits :-).

January 14, 2013, 9:50 am

Hi Max. I agree that taxes might affect the overall return. However, as Mike said, if you hold your dividend stocks in registered accounts, taxes are not an issue. In addition, each country taxes dividends differently. In any case, I’ll try to test the impact of taxes in the near future. Thanks for your comment.

Mark
January 14, 2013, 3:14 pm

I think you are forgetting that the price of the stock will have to go up at 15% as well to maintain 1% dividend. Would love to see a post on that.

I will send an excel sheet, if needed.

Jim
January 14, 2013, 3:44 pm

I agree with your analysis regarding the nominal amount of dividends earned over a 20 year period.

However, you have omitted the fact that increasing dividends 15% per year while maintaining a current yield of 1% would require significant capital appreciation over time. 15%/year.

In fact, if you include capital appreciation along with dividends to calculation TOTAL return over the 20 years, your graph would look completely the oppposite with the 1%yield/DGR15% being well over 2x the total return of the 5%yield/DGR5%.

There are two schools of thought in dividend investing. One focuses solely on the dividends and the income stream they produce, caring nothing for capital appreciation for a variety of reasons. Another looks at total return including dividends and capital appreciation.

You bring up logical points noting that it is downright impossible to forecast the DGR out after 5 years. Though I do imagine that if the sustained DGR rate was to fall from 15% to 10%, the yield would eventually rise from 1% to 3%, using your examples. The biggest risk facing low-yield high-DGR stocks is that the high DGR will turn out to be unsustainable. This could mean a sideways stock (or a plummeting one for that matter) as the yield catches up to be more in line with its new expected DGR rate (think JNJ over the last 5-7 years). In high-yield low-DGR stocks, you eliminate this risk, but you also elimiate the significant reward if you do find one that raises its dividend 15% per year for 20 years.

Whichever method a dividend investor feels more comfortable with is their own personal decision and I’m not advocating one way or the next as I own dividend stocks that would fit into all your examples.

It is true, that when you advocate high-yield low DGR companies, it is akin to “a bird in the hand is worth two in the bush”….except that sometimes one of those birds in the bush may be laying golden eggs.

January 15, 2013, 12:30 am

Hi Dividend Engineer,

Great analysis, but Jim is correct. I have run the numbers on the total return, and they quite different when viewed in perspective

Stock 1: Total return $167,000 – total dividends $12,000
Stock 2: Total return $102,000 – total dividends $24,000
Stock 3: Total return $61,000 – total dividends $29,000

So stock 3 did indeed have the most dividends, but if stock 1 is still trading at a 1% yield then the total return is far more. Total return is best estimated with the formula (return = dividend yield + dividend growth), so in your example it is 16%, 13% or 10% – and the results are fairly straightforward.

Of course it is hard to find any stock that maintains even 10% dividend growth over a 10 year period, let alone 20%, but an interesting theoretical discussion.

January 15, 2013, 9:37 am

Hi Everyone! Thanks for all your comments. When I wrote this post, I expected some reactions and I’m glad you all commented. In fact, some of your comments are worth their own post. First of all, I do agree with you that if we take into account the stock price, the stock having the highest growth will provide the highest return. However, what I wanted to compare here was the accumulated dividends. From that perspective, the stock having the highest yield wins. Second, with respect to stock price, my calculations assume that the stock price grows at the same rate as the dividend. Understandably, stock which price steadily grows 15% annually over 20 years are rare. If I could easily find them, I would be rich by now ;) In addition, though my calculations assume constant grow in the stock price, this is seldom the case. As you all know, stock prices can be very volatile, even for blue chip dividend stocks. So, as a dividend investor, I prefer to focus on the dividends I (will) receive than on the stock prices over which I have much less control. In future posts, I will play around with other numbers and scenarios. Stay tuned! TDE

January 15, 2013, 12:23 pm

Very good exercise Dividend Engineer. While I agree with some commenters above that if you are comparing Total Return, in these examples you would be better off going for the higher yield. But I think the first question every investor needs to ask themselves is what thier goal is. Personally I am in the accumulation phase so I look for higher growth. However, as I near retirement my focus will be more on current income and my portfolio will reflect that as I transition from lower yield higher growth stocks towards higher yield lower growth stocks.

I think you did a great job illustrating the different scenarios and retirees or those nearing retirement should consider the higher yield stocks so that they have current income. In retirement I would like to live completely off the dividend income rather than being forced to sell stocks to realize the capital gains to live off of.

January 15, 2013, 2:35 pm

Thanks Dan! I totally agree that it is critical to determine your goals before starting investing. Otherwise, there will be no common thread between each transaction. I too am in the accumulation phase and the stocks I hold yield on average 3%. However, I wanted to see if my approach was right. That’s why I tested these scenarios. Understandably, these scenarios may not apply directly to real life stocks. However, I was hoping to pick up (and share) some insights from the scenarios. TDE

January 15, 2013, 4:39 pm

Why does it have to be one or the other? :)

I hold a mix, stocks for yield and stocks for growth.

As I near retirement, I will likely shift to dividend growth.

This way, I take more risk out of the equation.

I will also increase my holdings in broad-market ETFs like VTI that pay some yield but I earn capital appreciation from; especially as yield becomes less important with a sizeable war chest :)

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January 17, 2013, 11:45 pm

One of the hallmarks of a great post is the discussion it generates, and yours has certainly done that!
My investing philosophy is similar to that described by My Own Advisor, with a mix of yields at the time of purchase (about 30 stocks ranging from a low of 2.2% up to a high of 7.6%, and an overall average yield of approximately 4.4%). I do tend towards a “total return” view more so than many dividend investors who pay more attention to dividend growth, but hey, if we all had the same approach there wouldn’t be a market!

January 18, 2013, 7:52 pm

Hi MOA and DoD. Thank you for your comments. To be honest, it does not have to be one or the other. I, like many, of not all of you, do own a mix of low yield/high growth stocks (e.g. Union Pacific (UNP)) and high yield/low growth stocks (e.g. Westpac Bank (WBK)). The key is proper diversification. Still, I wanted to see whether low yield/high growth stocks were better than high yield/low growth stocks, on the perspective of cash return. I fully agree with all of you that the growth in stock price must somehow be taken into account. Still, it’s by testing ideas that we progress and learn. And, debating is fun too ;) Have a nice week-end! TDE

January 21, 2013, 10:37 pm

I only sort of understand the value of these exercises, when I read posts like this I just don’t understand the applicability to the real world.

Like Jim and a few others said, when screening for a stock you can’t possibly look at the yield and growth in a vacuum.

I don’t believe that you do that just my main problem with using just numbers.

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