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: Merck (MRK) and Coca-Cola (KO).
|1-Year Div |
|5-Year Div |
These two companies are very clear contrasts in dividend strategy. Merck has a much higher dividend yield, but the dividend has not been increased since 2004. Also, Merck has a 110% payout ratio, which is dangerous for shareholders looking for strong dividends since it is taking everything Merck earns just to pay the dividend. This is one reason the dividend has not been increased in seven years.
Although Coke has a lower yield, its prospects for dividend growth are much better. The five-year dividend growth rate is solid at 9.5%, and their payout ratio is a healthy, low 34%.
In order to compare and contrast these two stocks, I want to show readers 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 current annual dividend divided by the original investment in the company’s stock. I ran these calculations using our publicly available calculator, called Dividend Yield And Growth. Starting with the simplified assumption that the growth rate of each dividend follows the five year growth rate, we see the following:
It takes about 6 years for the YOC for Coke to break even with the YOC for Merck. Of course, due to compounding, we see the YOC for Coke 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 Coke’s dividend growth rate continues at this high rate, it still takes nearly 10 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.
If we use the one-year growth rate for dividends instead of the five year growth rate, the YOC will break even in year 8 and the compounded returns will break even after 13 years. If I’m buying a dividend paying stock for the long run, and I had to make a choice between these two companies, I would lean towards Coke and its much stronger history of dividend growth.
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.