The Question: Is High Initial Yield or High Dividend Growth Best for Me?
As the yield from traditional sources of investment income such as bonds and CDs have withered in recent years, dividend stocks have become increasingly important to the income investor. Also important are stocks with a history of growing their dividends, as investors strive to reliably increase their future income. The income-oriented investor can easily find himself asking this question:
"Should I choose as stock with a high initial yield and a low dividend growth rate, or one with lower initial yield and high dividend growth rate?"
We begin answering this question by studying how much income is generated by each of the two scenarios over time. A simple spreadsheet exercise shows the cumulative amount of dividends from a $1,000 investment in two theoretical companies, with dividends reinvested:
Company HY: Initial dividend 3.5%, dividend growth rate 5% a year
Company HG: Initial dividend 2.5%, dividend growth rate 10% a year
The faster growing annual yield from company HG passes company HY in year 9 (5.36% vs. 5.17%), but the cumulative amount of dividends from company HG doesn't surpass HY until year 17 ($1662 vs. $1651).
This chronology also holds if dividends are not reinvested, as shown in the chart below. Cumulative dividends from high growth Company HG don't surpass Company HY until year 17 ($1014 vs. $1007).
To use a real world example, we can compare dividend growth powerhouse Walgreen (WAG) with current yield 2.69%, 10 year dividend growth rate 21.2%, to high dividend Altria (MO) with current yield 5.25%, 10 year dividend growth rate 11.4%. Yields and growth rates for all examples are taken from Dave Fish's U.S. Dividend Champions. The annual yield of WAG surpasses MO in year 12, pulls ahead of MO in cumulative dividends in year 17, and after 20 years has left MO in the dust far behind.
In another example, we compare high dividend growth Eaton Vance (EV), current yield 2.09%, dividend growth rate 18%, to high yielding Kimberly Clark (KMB),current yield 3.44%, dividend growth rate 9.5%. This time, because the initial yields are closer, the annual yield of EV surpasses KMB earlier, in year 8, and in the cumulative amount of dividends in year 12.
The answer to our initial question, high yield/low growth rate vs. low yield/high growth rate, depends on the needs of each investor. When an investor plans to tap his dividend money in 10 years or less, then the high initial yield company is preferred. If, however, the money will not be needed until longer than that, the high dividend growth company is preferred, with a much more rewarding return after about 15 years.
This article is a starting point for the dividend growth investor who is comparing investment options. There are many variables that affect future dividends, including changes in growth rates, differences in growth rates, and safety of the dividend. In addition, results will vary depending on the magnitude of differences between initial yields and between projected dividend growth rates. There are also important non-dividend considerations such as growth in the underlying share price. Uncertainty is the only certainty in investing. We improve our chances of success when we can gain some clarity on one of these dimensions of variability. The relation of initial yield and dividend growth rate is one such opportunity.