One of the decisions facing dividend investors is the choice between buying high current yield with a low growth rate, or purchasing a security with a lower yield but with faster growth potential. That decision involves several factors such as current age of the investor and current income needs. In this article we will examine two different situations often facing the dividend growth investor. Though I have taken some liberty with stable growth percentages in my examples, the end results justify the means.
In the tables below I prepared a 17 year study based on the current life expectancy of the typical male retiree at age 65. Our study examines the choice of buying a stock currently yielding 6% with a 3% estimate of future dividend growth compared to a stock yielding 3% but with an 11% growth factor.
The 6% Yield with a 3% Growth Rate
In the table below, in year 17 (assuming a straight line growth of 3%), the 6% shares would be yielding 9.6% on cost, a 60.47% growth in annual dividend payments. During that period of time one collected $13.06 in dividend payments. In addition, the share price would grow from $10 to $16.05.
A 3% growth in the shares and dividend is the approximate rate of inflation that the United States historically averages. So an investor buying a high current yield that offers only a small growth factor, can protect themselves not only against normal inflation rates, but provide a healthy 6% income flow.
The 3% Yield with a 11% Growth Rate
Now we will contrast the preceding example with a security yielding 3% and a 11% growth rate for earnings and dividends. Current examples might include companies such as McDonalds (NYSE:MCD), or Proctor & Gamble (NYSE:PG) though neither are perfect examples. As can be seen from the chart below, it takes 17 years for the dividend payment to grow enough to equal the 6% example in the preceding comments. However, the final dividends are much greater as the 17th year payments have grown to a yield on cost of 15.9%. The shares have grown from $10 to $53.11 a share:
It is thus clear that both examples deliver to the investor the same total dollar amount of dividend payments over the 17 years, but differ quite a bit on the road to that figure. The larger starting yield of 6% is front loaded while the 3% example is back-end loaded, but at the 18 year mark the faster growth becomes the winner in producing income. In the tenth year the annual dividend payments are roughly the same.
Conclusion: Clearly each individual investor must make a choice between the two examples based on individual needs. For those that are able to sacrifice current yield for future growth, the payback in total dollars and capital appreciation of the faster growth stock is superior.