This article is the first in the series of articles I will use to describe my investing method. These are meant to be informational and contain information that will help me as I invest. I have tendency to forget what a metric means. The research in this series will provide the basic information and examples that will help me. Many of these articles will be basic, but I have friends/family reading this that are new to investing. Hopefully it helps them and you too!
Now for Dividend Yield and Growth!
What is a dividend? A dividend is a payment that a company pays to its shareholders from profits. This is a way for the owners to share in the spoils of the business.
What is a dividend yield? The dividend yield is the market price of the stock divided by the total amount of dividends paid in a year. For example, if ACME’s current market value is 100$ per share and they pay 2.5$ per year in dividends, their yield is 2.5/100 = 2.5%.
What is a dividend growth rate? Percentage at which the dividend changes over a period of time. Commonly, you will see 5-year, 10 year and most recent growth rates. These rates are calculated using the Compound Annual Growth Rate (CAGR).
How I use them:
When I look for dividend investments, I attempt to look for stocks with an entry yield higher than 2.5%. When I use a stock screener, I usually set the lowest yield to 2.0. While I may not purchase a stock below 2.5, I like to keep track of which stocks are near it and keep them on a watch list. As the price of a stock fluctuates, individual securities move up or down around my dividend entry criteria. Walmart, for example, has a tendency to stay in the 2.3 to 2.6 range.
Next, I attempt to find stocks with a minimum dividend growth. It must be positive with no dividend cuts and three or more years of growth. Three years isn’t enough to demonstrate to a potential shareholder the commitment to pay a dividend, but it can yield hidden gems that will potentially raise their dividends quicker. Most of my large positions will have dividend growth streaks over 10 years. A fantastic resource for finding these types of dividend stocks is the U.S. Dividend Champion spreadsheets created and maintained by Dave Fish.
Given a combination of growth and yield, I generally like to start with yields closer to 3 and 5 year growth of 8-10. I do not mind having some strong dividend growers in the portfolio with lower yields. There are plenty of high quality companies yielding more than 2.5 (KO, PEP and PM for example), this higher yield criteria is not hard to find. On the flip side of the coin, I will have some stocks with larger yields and slower growth like AT&T(T) and Realty Income (O). It’s a matter of balance. A few higher yielding investments enable me to accumulate funds faster to buy securities that grow faster.
Illustration of dividend growth:
I will examine three scenarios, each with a different yield and growth rate. What do you think will perform the best? Higher growth/lower yield or higher yield/lower growth? Let’s see.
|Scenario||Rate (%)||Dividend Growth (%)||Years to reach $1549|
Interesting! The 3 and 3.5% scenarios are neck in neck to reach 1549 dividends per year, while the larger yield of 4%, but lower growth, is years behind. This demonstrates the importance of dividend growth, even with portfolios that start at a higher yield.
The graph demonstrates how a low yield with high growth can overcome the initial gap between yields. The scenarios I chose seem somewhat arbitrary, but I wanted to illustrate that getting the highest starting yield possible can be defeated by a strong consistent growth rate. Dividend growth rates do not stay this constant and will vary over the years as companies go through peaks and troughs.
The next question that you may be asking yourself is, what is the difference in dividends earned per year and what are the overall dividends?
|Scenario||Divs @ 30||Total Divs @ 30||Divs @ 30 reinvest||Tot. Divs reinvest|
As the years go on, the High Growth scenario destroys the other two. At year 30, you would receive 10,708 in dividends per year (which is calculated by initial-divs * (1+ growth rate) ^ number of years). Hopefully my math is right! This value is more than double the highest yielding yet slowest growth.
The final two columns demonstrate the effects of reinvesting your interest. As your investments pay you, you can either save the money or reinvest. These columns demonstrate what happens if you reinvest those dividends at the start of the next year (compounded annually). Basically, you get two raises. The dividend growth that happens during the year and the reinvestment of the dividends. The reinvestment numbers may be low because once you have accrued enough, you will reinvest the dividends instead of waiting until the end of the year (compound quarterly or monthly vs. annually). This was merely for demonstration purposes and simplicity.
What if I just started with a higher yield? You definitely could have and there are yields with enough growth that would beat all the scenarios demonstrated above. However, with great reward comes greater risks. The goal is to keep risk as low as realistically possible, given the nature of these investments. A high yielding dividend isn’t necessarily unsafe, but maintaining the dividend may be hard when a rough patch is hit. Due diligence is key!
There is no fixed yield/growth rate that will work for everyone. Depending on your circumstances, you may need more yield or growth. I have a long time till I want to live off of the income, so I can make due with a lower starting yield and higher growth. Over the years, my research has lead me to believe that the “realistic” scenario of 3.5% with 8 percent dividend growth is an achievable long term goal. Only time will tell!
The provided examples make a strong case for dividend growth investing. There is more to investing than pretty charts and stock prices. These examples are illustrative of the potential of dividend growth investing, but unlike numbers the market doesn’t behave in a consistent fashion. Good investments go down and bad go up. I feel this strategy will give me the best opportunity to reach my financial goals.
Thanks for reading!
Disclaimer: Long KO, O, PEP, PM,T,WMT