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 being equal, should one invest in the company that has that enticing high dividend yield, but a low dividend growth rate, or does one exert 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 each that offers one of these different alternatives: Procter & Gamble (PG) and Eli Lilly (LLY).
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.
Starting with the simplified assumption that the growth rate of each dividend follows the five year growth rate, we see the following:
It takes 8 years for the YOC for Procter & Gamble to break even with the YOC for Eli Lilly. 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. Also, if we assume that PG’s dividend growth rate continues at this high rate, it still takes nearly 13 years for the compounded total return due to dividends to break even with Eli Lilly, 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.
The 1 year growth rate in dividends for Eli Lilly is 0%. Let’s also look at a more dire scenario for Lilly where their dividend does not grow at all and PG continues at the five year growth rate of 11.4%.
The yields on cost break even in about 5 years in this scenario and the time it takes for the compounded return due to dividends to equalize is slightly less than 8 years. Click to enlarge:
When constructing a dividend portfolio for the long run, it is important to keep in mind just how long it might take for a lower dividend yield to catch up with a stock that pays a higher yield. That low yield stock that you think will have stellar dividend growth rates might still not be worth putting in your portfolio until the dividend yield has risen enough to make it worthwhile.
Readers can input their own assumptions for any stocks and see the break-even yields on cost as well as compounded rates of return due to dividends using the same calculator that I have used for this analysis. It can be found under the page for free financial planning tools. The calculator is called Dividend Yield And Growth.