There have been several articles lately on the topics of yield on cost (YOC) and dividend growth rates (DGR) with a primary question being what conditions lead to higher dividend income (see articles by Clay King and Five Plus Investor). Should investors choose a high-yielding stock with a lower dividend growth rate, or a lower yielder with a higher dividend growth rate? How do these compare to fixed income investments, such as preferred stock or bonds? I believe it is a given that the higher dividend growth stock will eventually pass the lower yielder, but the more interesting questions are how long will this take and how does this vary depending on the assumptions? This becomes the time period for which any parameters made must hold true, and predicting a high DGR for 10-20 years is a potentially heroic assumption.
In prior articles, example calculations and graphs were provided to illustrate the advantage of high DGR stocks, though as myself and other SA members have noted, they often don’t look at the issue from a discounted basis or a cumulative dividend basis, or there have been some calculation errors. To resolve this, and to provide a useful analysis tool, I created a spreadsheet that you can download here. I believe the calculations are all correct, but if not, I can quickly make corrections. The rest of this article walks through the spreadsheet, which contains some sample data, and notes some interesting observations, particularly for those in retirement or who have a shorter timeframe. If you download the file first, you can then follow along.
The top section is set up to allow 3 stocks to be compared against a benchmark security. You can input the stock names, current yields, projected DGRs, and an amount to invest. The spreadsheet has separate sections for YOC and actual dividends earned, so you will get to see how the YOC changes as well as nominal and discounted dollar amounts. Note that the DGR assumption is constant for the entire model. I could modify the model to allow for a second rate that kicks in after a certain year, which might be more realistic, since a 15% DGR for 20 years is unlikely. But for now, this is on par with what other authors have done. There is also a box for a discount (inflation) rate. I am using 3%, which may be a little high for current inflation, but over the long term that is about right, though we perhaps should factor in the risk of dividend cuts or freezes. Higher discount rates will raise the present value of higher-yielders relative to stocks with lower current yield. You are free to alter these numbers as you wish.
I included some sample stocks from the CCC lists to represent lower yield with moderate DGR group (UGI and SYY), lower yield with higher DGR (ABT, JNJ, and INTC), and higher yield with lower DGR (T, VZ, and MO). For my benchmark, I am using FGE, which is a preferred stock of NextEra Energy (NEE) that Five Plus Investor referred to in her recent article. It has a yield of 7.45% and no dividend growth.
Click to enlarge charts
YOC, Dividends, and Cumulative Dividend Section
The next section shows the yield on cost, annual dividends received, and cumulative dividends received for each of the four securities on both a nominal and discounted basis. The annual dividend sections basically mirror the yield on cost sections, but multiply the percentages by the amount invested to show actual dollar amounts. Similar to the work by other authors, this model is ONLY looking at dividends, not total return, so the focus is on investors looking at a dividend stream for income purposes. To help visualize the break-even points, the rows have conditional shading; when the stock’s value exceeds the benchmark’s value, it is colored in.
Some articles have focused on reaching a 10% YOC or the point where the dividend growth stock’s annual dividend passes that of the lower yielder or fixed income security. One of my concerns, which I’ve voiced in those articles, is that while the high DGR stock may achieve a higher YOC by year 9 or 10, the high yielder earned more dividends in the prior 9 or 10 years. We need to look at the cumulative dividends, where we observe that the two streams are not equal until years 16-20, depending on which example we are looking at. Furthermore, when factoring in the inflation (discount) rate, dividends received earlier will have more value in real terms. In the spreadsheet, you will notice that the discounted breakeven points are 1 to 2 years beyond the nominal values. At a higher discount rate, this spread would increase.
This chart shows that on a discounted basis, the total dividend stream for a fixed income security at 7.5% with no growth produces more income than a low DGR 6% yielder, such as AT&T for around 20 years. Perhaps fixed income securities aren’t so bad after all. The risk is lower, as bonds and preferred stocks have higher payment priority than common shareholders, and the rate is fixed, whereas we will need AT&T to deliver dividend growth for 20 years to match this. Granted, a 2.5% DGR isn’t hard to achieve, but for other stocks with higher DGR, it may be. In any case, I believe this helps to show that there is room for fixed income investments in an income portfolio, both for diversification and risk management purposes, as well as to provide good yield and dividend streams over an extended period of time.
Creating a Synthetic DGR Stock from Fixed Income Securities
Some investors prefer DG stocks because then their income stream rises each year, whereas a fixed income security has a constant, though initially higher, payment. In the comments for another article, someone mentioned the idea of reinvesting the surplus dividends from the fixed income security as a way of increasing the dividend stream. I was curious how this would impact the results, so the final section of the spreadsheet provides a model for this. Stock A is compared to the benchmark, and you can set the reinvestment rate. Given that the investor is making a choice between the fixed income investment (7.45% yield, no growth) and a DG stock (3.5% yield, 7.5% DGR), this suggests that the investor can live off of a 3.5% yield. Therefore it is reasonable to invest the balance and effectively grow the income stream going forward. The only issues are what the reinvestment rate is and the risk to the reinvested money, since it will eventually be drawn down.
Rates now are historically low, so I used a slightly higher rate as an average CD rate, which has no risk to principal. Short-term TIP ETFs (STPZ) are another choice around 3.05%, or the investor could buy more preferred stock at 7.45%, but then the price could potentially drop. Factoring in this reinvestment extended the time until breakeven by two more years to 22 years, compared to the nominal cumulative dividend section. At a 7.45% reinvestment rate, it would take 27 years to breakeven, assuming a constant price for reinvested dividends.
Again, I believe this helps investors to feel more comfortable with owning fixed income investments, especially for retirees with a shorter time frame. 20 years is a long time, and you aren’t doing worse than a DG stock from an income standpoint. The total return would likely be less than the DG stock though. This last section also provides a means for converting a fixed income stream into a synthetic dividend growth stream to match the payouts of a DG stock for at least 20 years, without the need to rely on dividend increases.
I believe this spreadsheet will be helpful to investors who are comparing stocks with different yields and DGR. Keep in mind that it is based on constant assumptions, which may or may not hold true for a 20-year period. If the current yield spread is wide, the lower-yielding option may need over 20 years to achieve a discounted dividend stream equal to the high yielder, and more dividends are received in the earlier years. For those reinvesting all the dividends (accumulating), this is something to think about. This model does not factor in reinvestment, which could push the breakeven points out even further. Ultimately, we depend on the stocks continuing to achieve whatever growth rates we assume.
Personally, I believe the best option is a mix of high-yielders with lower DGRs, and moderate-yielders (3%+) with higher DGRs, which allows for a portfolio yield over 4%, a favorite number of many SA readers, and a decent average DGR. I have some preferred stocks, corporate bond, REIT, and BDC funds as well for yield and diversification purposes.