When looking to build a long-term portfolio of stocks that pay high dividends, investors usually come up with a mix of stocks that either have high dividend yields or high dividend growth rates. It is difficult to find good companies that have both. This means that there is often a choice to be made. All else equal, should one invest in the company that has that enticing high dividend yield, but a low dividend growth rate, or does one exude patience and invest in the company with a relatively low yield, but a high dividend growth rate? To help answer this question I looked at two companies that offer these different alternatives: Procter & Gamble (NYSE:PG) and Merck (NYSE:MRK).
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There are clear differences in the two companies' dividend yields as well as the growth rates. This presents a great case study in which company will give the investor a greater return due to dividends over time. More specifically, I want to measure the Yield on Cost (YOC) and how it changes over time as well as the compounded annual return due to dividends. The YOC simply measures the annual dividend divided by the original investment in the company's stock.
I started with the simplified assumption that the growth rate of each dividend follows the five-year growth rate. I ran the following results in our free calculator called Dividend Yield And Growth.
It takes 4 years for the YOC for Procter & Gamble to break even with the YOC for Merck. Of course, due to compounding we see the YOC for Procter & Gamble explode upward eventually. But this assumes that the company can continue its relatively high rate of dividend growth going forward.
If we assume that PG's dividend growth rate continues at this high rate, it still takes nearly 8 years for the compounded total return due to dividends to break even with Merck, assuming dividends are always reinvested. 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.
Another interesting way to look at this is, what does Procter & Gamble's dividend growth rate have to be in order for the returns to break even after only 4 years rather than 8 years? I kept Merck's dividend growth rate set at 2.9%. It turns out that Procter & Gamble's dividend must grow at a 17% annual rate in order for the returns to break even after 4 years.
Both of these stocks could be very nice additions to retirement portfolios. However, I am a bigger fan of Procter & Gamble because of their higher dividend growth rate, lower payout ratio, and recent history of increasing their dividend substantially during the recession of 2007-2009.
Lastly, I have found by plugging in various dividend yields into our Retirement Planner that finding dividend payers who can return just 2% more than bonds or other dividend payers can increase the time that funds last in retirement by more than a decade. The key is finding companies who will either pay a strong dividend or have serious dividend growth and have shown a culture of not cutting dividends when times get tough.
Disclosure: I am long PG. 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.