Many investors, including myself, have been picking through companies over the past five years, looking for those that are not too cyclical and can withstand slow economic growth. Two of these companies that I've found are Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST).
Some investors shy away from these two stocks due to their relatively low dividend yields, but it's important to keep in mind that their dividends have been growing at a healthy rate, even during the brutal downturn of 2008 and 2009. So I wanted to compare these two companies over time and see how investors might fare over a long time horizon if they buy these stocks for the dividend.
Many will rightly scoff at Costco's small dividend yield, but it's important to point out that it did recently pay a special dividend of $7 per share at the end of 2012. Also, the one-year dividend growth rate is nearly 16% while Wal-Mart's has come down a bit to 9%.
Let's take a look at how these two investments might fare over time. I ran the following analysis in our free calculator called Dividend Yield And Growth over 20 years and I assumed the dividend growth rates followed the one-year growth rate:
It takes about 14 years for the YOC for Costco to break even with the YOC for Wal-Mart. However, even more important than the YOC is the compounded total return over time. We can see that Costco's compounded return simply never breaks even with Wal-Mart's. Its higher dividend growth rate is not enough to offset its relatively low starting yield. It is also important to note that I do not consider any price appreciation in these calculations and compounded returns are due solely to dividends.
So what does Costco's dividend growth have to be before the compounded returns over a 20-year time frame break even? The answer is 18%. Or put another way, Costco's dividend growth rate must be about 9% points higher per year in order for it to break even to Wal-Mart over a 20-year time horizon.
It is clear from this exercise that looking at dividend yield is not enough. One must have some type of forecast for dividend growth going forward, otherwise it is impossible to make a sound decision on which dividend paying stocks to buy. It is also clear that dividend investors must have some type of forecast for dividend growth before they can make a sound decision on where to put their money.
Disclosure: I am long WMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.