Dividend Growth vs Dividend Yield

Dividend Growth

There appear to be two camps in the dividend investing world.  On one side are investors who believe in putting money into firms with lower dividend payments but correspondingly low payout ratios that may be predisposed to generous dividend increases going forward.  On the flip side of the coin are investors who believe it’s fine to put money into firms with high payout ratios and higher dividend yields but limited dividend growth potential. 

In an ideal world, we would all invest in firms with respectable or above average dividend yields that also paid out a reasonably small percentage of earnings in dividends, all things being equal.  Unfortunately, this fortuitous combination doesn’t appear often.

The merit of investing in lower yield, lower payout ratio firms revolves around the possibility of future dividend increases.  For instance, if a firm delivers a 2% yield, but pays only 38% of its earnings in dividends, the argument says there’s room for healthy and frequent dividend increases since there are earnings aplenty with which to make those payments.

What’s generally left unsaid is that the firm’s management must allocate a larger percentage of those earnings to dividend increases for the forecast upside to materialize.  This doesn’t always happen.  Consequently, the prospect of better dividends and higher yields ahead can be left wanting.

Conversely, firms with higher dividend yields and high earnings payout ratios aren’t perceived as having sufficient funds to further increase dividends in the future.  As an example, a firm using 90% of its earnings to offer a dividend yield of 6% may be viewed by investors as incapable of increasing the dividend payment in the future.  Consequently, it may not be worthy of an investment as far as they are concerned.

It’s easy to see the logic behind both positions.  As a result, I thought I’d look at the math to see if one side made more sense than the other.  For this exercise I’m pitting a firm (A) paying a 6% yield, with no dividend growth, against a firm (B) paying a 4.5% yield growing its dividend by 10% annually.  Dividends are reinvested so compounding is in effect.  To keep things simple both firms have stock prices of $100 and with only 1 share of stock involved per firm.  The price holds steady through the exercise and the period is 5 years.  Below are the tables comparing the two scenarios.

Company A - High Yield, No Growth
Years     0	1	2	3	4	5
$ 100.00	$ 106.00	$ 112.36	$ 119.10	$ 126.25	$ 133.82
Divs Paid	$     6.00	$     6.36	$     6.74	$    7.15	$     7.57

In the case of Company A, the single share of stock with a 6% yield paid $41.85 in dividends during its 5-year period while holding yield and price constant.

Company B - Low Yield, High Growth
Years    0	1	2	3	4	5
$ 100.00	$104.50	$ 109.45	$114.90	$120.88	$ 127.47
Divs Paid	$    4.50	$     4.95	$    5.45	$    5.99	$      6.59

Company B, during the same 5-year period, paid only $27.47 in dividends despite growing its dividend payment by 10% year-over-year.  By the end of the 5^th year, the stock is yielding over 6.5% which exceeds the yield on Company A stock despite having paid only 65.6% of the dividends that company A did.

Extending the exercise out to the point at which Company B with its growing dividend stream has paid more in dividends than Company A with a high, but steady yield, means calculating through year 11.  In other words, Company B would have to increase its dividend by 10% per year for 11 years before it paid more in dividends than Company A does in 10 years.  Furthermore, the yield on Company B’s dividend would exceed 10% in year 11.  All this assumes, of course, that Company B’s management can maintain such a torrid dividend growth rate for more than a decade.  The probability of doing so appears remote to say the least.

Based on our exercise, I’m likely to preference solid, high dividend companies with high payout ratios over firms with low payout ratios and lower yields, all things being equal.  This despite the hope of future increases with the low payout ratio firms. 

High Dividend Yields Can Help.

It’s true a high dividend, high payout ratio company can lower its dividend, but I think it unlikely since CCC companies protect their dividend payments with enthusiasm.   

Conversely, I believe it’s even less likely that a low dividend “grower” will be able to exceed the lifetime dividend payment stream of the high yield firm even with excellent dividend growth given the length of time and level of persistence required to do so.

The thoughts and opinions expressed here are those of the author, who is not a financial professional, and should not be considered as investment advice. The information is presented for consideration and entertainment only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional