Dividend investors often set minimum requirements for an "acceptable" initial dividend yield and/or dividend growth rate.
Thus one investor might say, "I won't invest in a dividend stock with a yield of less than 3%." Another might say, "I want a company that increases its dividend at least 10% per year." A third might demand that any stock he or she buys have increased its dividend for 25 years in a row.
One of the primary goals in dividend investing is to purchase stocks whose yields and dividend growth rates combine to make them better bets than safer fixed-income investments like money market accounts, certificates of deposit, and bonds, which normally offer lower yields at less risk.
The dynamic that determines the long-term dividend return of a stock is how its initial dividend yield (that is, the yield at the time you buy it) interacts with its annual dividend growth rate.
Obviously, a stock with a 5% initial yield growing at 10% per year will achieve a target return sooner than a 2% initial yielder growing at the same rate. Conversely, a 3% initial yield growing at 10% per year will at some point permanently surpass the dividend return of a 5% initial yielder growing only at 5% per year.
The question becomes, when do those lines cross? And as an investor, are you comfortable with how long it takes for the faster-growing 3% yielder to pass the 5% stock growing more slowly?
Most dividend investors have a long-term holding period in mind when they buy dividend stocks. They are not looking to trade them often, but rather to hold them, allowing time for the dividends to increase and compound, until the stock itself becomes a money-generating machine irrespective of the stock's price fluctuations.
Here is a useful way to look at this: Select stocks that will achieve a 10% dividend return on your original investment within 10 years' time. I call this the "10 by 10" approach.
The two 10s are arbitrary, of course. You can put in any goals you like. I chose 10 and 10 because:
- 10% is a healthy rate of return, almost equal to the long-term total return of the stock market itself, which most studies place between 10% and 11%. (Total return includes price appreciation as well as dividend return.)
- 10 years is a useful time frame for people of most ages. Young people, of course, have a much longer investment timeframe, but nevertheless may consider 10 years plenty long enough to wait for the kind of ultimate return they are seeking. Older people—say in their 60's and 70's—still often think in timeframes at least as long as 10 years, since just by having lived to their current age, their life expectancy usually is longer than 10 years from right now.
- And, of course, 10 is a nice round number. It is easy to think in terms of 10% return and a 10-year timeframe to get a good grasp of the underlying principles.
So the question is reduced to simple math: What initial yields, compounded at what rates of growth, achieve the 10 by 10 goal, namely a 10% dividend return within 10 years?
The following table answers that question. It shows initial yields (across the top) and annual growth rates (down the side). Where any two values intersect, the table shows how many years it takes to achieve a 10% dividend return. Beneath the table are a few notes on calculation and interpretation.
- The table ignores the contribution of price increases. It shows only the rate of return based on increases in the dividend over time.
- The rates of dividend increase should be considered average annual rates. It is rare for a company to increase its dividend by the same percentage each year.
- The table does not include the accelerating effect of reinvesting the dividends, which would shorten the times shown. It just shows the increase in your yield from growth in the dividend itself.
- In calculating the table's values, all years were rounded to the nearest year that a 10% return (from dividends alone) would be achieved. Thus all years appear as whole numbers.
- Returns were also rounded, so the year that a return reached 9.6% was counted as the year it hit 10%.
- The "sweet spot" wherein the 10 by 10 goal is achievable has been shaded. So, for example, a 4% initial yield growing at 10% per year achieves the same result as a 5% initial yield growing at 7% per year: Both reach a 10% return (from the dividend alone) in about 10 years.
A few interesting conclusions jump out from this table.
First, a 2% initial yield cannot reach the 10 by 10 goal at any rate of increase up to 15% per year. "You can't get there from here." For that reason, many of S&P's "Dividend Aristocrats" (stocks that have increased their dividends for at least 25 years running) do not clear the 10 by 10 hurdle. This would include such common dividend-stock names as Air Products & Chemicals (NYSE:APD), Archer-Daniels-Midland (NYSE:ADM), and Weyco Group (NASDAQ:WEYS).
Second, the table demonstrates that the initial yield carries somewhat more weight than the rate of dividend growth. For example, an additional 1% in initial yield reduces by 2% to 4% the growth rate needed to reach 10% return in a given time. In the example cited earlier (see note number 6 above), a jump in initial yield from 4% to 5% reduced the dividend growth rate needed to achieve the 10 by 10 goal by 3% per year.
This latter point is important. The faster you hit your 10% dividend return rate goal, the fewer years that your stock choice is subject to the risk that you overestimated its rate of dividend growth. As all dividend investors know, their initial rate of return is fixed at the time of purchase, but the future rate of dividend growth is somewhat speculative. Also, the higher the rate of projected dividend growth, the more risk that it may not actually be achieved.
So getting to your goal in fewer years is generally better all around. Looking again at some common Dividend Aristocrats, names like AT&T (NYSE:T), Kimberly Clark (NYSE:KMB), and McDonalds (NYSE:MCD), all yielding more than 3.5% to new purchasers, seem like better bets than the lower-yielding stocks named earlier, simply because their initial yield is higher.
Of course, before purchasing any stock, you should perform your own due diligence on other factors like projected growth rates, valuation, and the like. Be particularly wary of very high yielding stocks...their dividends may be at risk. So the initial yield and historical dividend growth rates are just starting points in the analysis.
As stated earlier, investors with other goals may plug in different numbers besides the 10 and 10 that I selected. Maybe you want to achieve 12% dividend yield within 9 years, or 10% within 7 years. It is easy to modify the table to show the combinations of initial yield and dividend growth rate you need to achieve those goals. The underlying principles and simple math remain the same.
Disclosure: Long KMB and MCD.