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Dividend investors have long debated over the appropriate allocation with regard to choosing between high current yield and a high dividend growth rate. For some the decision is essentially made for them; those who necessitate current income. But for the rest of us long-term investors, there is a strong argument to not just look at the current yield but to also consider the rate at which payouts are growing.

I myself recently weighed in on this issue with regard to the higher yields but low dividend growth rates of utility stocks. The article specifically underlines the idea that one can find more appropriate alternatives than utilities. That is, if they’re looking to create lasting wealth via the highest yield on an initial cost basis. I stand by this concept; however it is important to also take into consideration the immediate benefit of a higher current yield. A higher yield acts as such a buffer, that it is possible for an alternative investment to have a higher yield on cost and yet not provide greater immediate value.

Perhaps a variety of examples will illustrate these points more clearly. No matter how much you love dividend growth, the simple attraction of a super high yield oft turns even the most stubborn investor’s head. Most to this point, let’s look at the last decade of payouts for Annaly Capital Management (NLY), which had a current yield around 16% at the start of 2002.

Annaly (NLY)

Initial Yield

2002 Open

$16.00

16.19%

2011 Close

$15.96

Annual Dividend

Cumulative Dividend

Dividend per Dollar Invested (Yearly)

2002

$2.59

$0.16

2003

$2.16

$4.75

$0.14

2004

$1.95

$6.70

$0.12

2005

$1.44

$8.14

$0.09

2006

$0.48

$8.62

$0.03

2007

$0.89

$9.51

$0.06

2008

$1.92

$11.43

$0.12

2009

$2.29

$13.72

$0.14

2010

$2.76

$16.48

$0.17

2011

$2.51

$18.99

$0.16

$1.19

2011 YOC

% of cost in dividends

15.69%

118.69%

From 2002 to 2011 the payout actually decreased for NLY, but to be fair, it has been increasing substantially in the last 5 years. Although to be complete, this was a direct result of an even larger decline in the years prior. Still, Annaly managed to pay out an astonishing 118% of its 2002 cost basis in just the last decade. For long-term NLY investors, this means that today they’re effectively “playing with the house’s money,” as they were handed an 8% annualized return in lieu of price appreciation.

Perhaps this is an extreme example, but it does show that if the high, or in this case super high, current yield is sustainable over time, investors can benefit. A more realistic example for the dividend growth investor would be to compare two well-established dividend growth companies with more reasonable yields. Let’s take a look at the payouts of AT&T (T) and McDonald’s (MCD), with their respective 5.9% and 2.8% current yields.

AT&T (T)

Initial Yield

2002 Open

$39.25

2.72%

2011 Close

$30.24

Annual Dividend

Cumulative Dividend

Dividend per Dollar Invested (Yearly)

2002

$1.07

$0.03

2003

$1.12

$2.18

$0.03

2004

$1.25

$3.43

$0.03

2005

$1.29

$4.72

$0.03

2006

$1.33

$6.05

$0.03

2007

$1.42

$7.47

$0.04

2008

$1.60

$9.07

$0.04

2009

$1.64

$10.71

$0.04

2010

$1.68

$12.39

$0.04

2011

$1.72

$14.11

$0.04

$0.36

2011 YOC

% of cost in dividends

4.38%

35.96%

From 2002 to 2011 AT&T grew payouts by about 5.4%. This isn’t overly impressive, especially given the large price decline, but the total $0.36 of dividends received per dollar invested does represent an average yield of about 3.6% over the period. Something I am sure would have attracted dividend investors buying T in 2002 with an initial yield of 2.72%.

McDonald's (MCD)

Initial Yield

2002 Open

$26.47

0.89%

2011 Close

$100.33

Annual Dividend

Cumulative Dividend

Dividend per Dollar Invested (Yearly)

2002

$0.235

$0.01

2003

$0.40

$0.64

$0.02

2004

$0.55

$1.19

$0.02

2005

$0.67

$1.86

$0.03

2006

$1.00

$2.86

$0.04

2007

$1.50

$4.36

$0.06

2008

$1.625

$5.98

$0.06

2009

$2.00

$7.98

$0.08

2010

$2.26

$10.24

$0.09

2011

$2.53

$12.77

$0.10

$0.48

2011 YOC

% of cost in dividends

9.56%

48.24%

As you can see from the table above, MCD performed remarkably better than AT&T during the same time period. Even without considering the monumental price appreciation, MCD managed to move its initial yield from 0.89% in 2002 to a 2011 yield on cost of about 9.6%. This compares to AT&T’s 2.7% initial yield and 4.4% 2011 yield on cost. This extraordinary increase was due specifically to McDonald’s ability to increase dividends by an average yearly rate of 30.2%. Much like the NLY example, the MCD vs. T demonstration could be considered a bit extreme. However the underlying thesis remains the same. That is, even though T had a much higher initial yield, MCD was able to crush its dividend return by having a very high dividend growth rate.

Let’s try to find a less extreme example, and look at "Generic Inc.," a company that I invented for purposes of demonstration. It is given an initial yield of 4%, with a constant dividend growth rate of 5%. Not unlike many Utility stocks today.

Generic Inc

Initial Yield

2002 Open

$25.00

4.00%

2011 Close

Annual Dividend

Cumulative Dividend

Dividend per dollar invested (Yearly)

2002

$1.00

$0.04

2003

$1.05

$2.05

$0.04

2004

$1.10

$3.15

$0.04

2005

$1.16

$4.31

$0.05

2006

$1.22

$5.53

$0.05

2007

$1.28

$6.80

$0.05

2008

$1.34

$8.14

$0.05

2009

$1.41

$9.55

$0.06

2010

$1.48

$11.03

$0.06

2011

$1.55

$12.58

$0.06

$0.50

2011 YOC

% of cost in dividends

6.21%

50.31%

For the 2002 to 2011 period, a company that begins with a 4% current yield and grows dividends at a constant 5% a year ends up with a yield on cost of about 6.2%. Notice that this is well below McDonald’s yield on cost of 9.56%, yet during this 10-year period the Generic Company, with a high current yield and moderate growth rate, actually returns more dividends per dollar invested than MCD. The initial high yield of the Generic Company acts as such a buffer that even with MCD’s higher yield on cost, achieved in just 6 years, the moderate dividend growth provides higher returns.

There are two important notes here. First, the price for the generic company was not included, as it is made up. (Although you could value it in perpetuity, it’s not important.) It is recognizable that MCD had a fantastic price appreciation in the given time period. However, it is also possible that another company would have a high dividend growth rate, but not such a fantastic price appreciation. The point here is that dividend growth is important to create a higher yield on cost, but this alone does not necessitate a better investment.

The second important note is that if you run this model in the 11 year, MCD will outpace the generic company in dividends paid per dollar invested. If you look to other companies with a smaller dividend growth rate, yet still higher than 5%, this would occur later in the process. However, it is a matter of math that this will eventually occur.

We have thus far learned that a very high current yield should not be ignored if it is perceived to be sustainable and that a higher dividend growth will eventually lead to greater dividend payouts in total. While the given examples were extreme, it should be made clear that for companies with more conservative yields and growth rates the actual comparison becomes much more paramount. Such that one cannot simply look at a projected yield on cost in the future and make an investment decision.

Here are some total payout examples:

Coca-Cola (KO)

  • Current yield 2.7%
  • 10-year average dividend growth rate = 10.1%
  • Amount of time it would take KO to provide a higher total payout than a company yielding 4%, with a constant 5% growth in dividends = 15 years

PepsiCo (PEP)

  • Current yield 3.1%
  • 10-year average dividend growth rate = 13.3%
  • Time it would take PEP, versus 4% yield, 5% dividend growth = 8 years

YUM Brands (YUM)

  • 1.9% current yield
  • 5-year average dividend growth rate = 14.6%
  • Time it would take YUM = 15 years

Wal-Mart (WMT)

  • 2.5% current yield
  • 17.9% 10-year average dividend growth rate
  • Time it would take WMT = 8 years

Procter & Gamble (PG)

  • 3.1% current yield
  • 10.9% 10-year dividend growth rate
  • Time it would take PG = 10 years

Exxon Mobil (XOM)

  • 2.2% current yield
  • 10-year average dividend growth rate = 7.4%
  • Time it would take XOM = 40 years

PPG Industries (PPG)

  • 2.7% current yield
  • 10-year average dividend growth rate = 3%
  • Time it would take PPG to surpass a company yielding 4% and consistently increasing its dividend by 5%, given a PPG growth rate of 3% = Never (In fact, the gap would widen every year)

The overarching point is that while the yield on cost of these dividend growth companies might exceed another investment quickly, it is paramount to also consider the total payouts returned. If one were to simply look at future yield on cost, there might be a disconnect as to which investment provides greater value in the given time period. It is true that a higher dividend growth rate leads to a higher total payout return. However, one must also consider their specific time-horizon – are we talking the 8 years of PepsiCo and Wal-Mart or the 40 years of Exxon Mobil? Just how long-term is your holding period?

Of course there are a variety of other reasons to invest in companies rather than just dividend payouts. One might, for example, believe in the underlying prospects of the company and be looking for price appreciation. Or one might select a high-yielding company without much dividend growth and use these payouts to reinvestment in more attractive investments. But if you’re mainly focused on the predictive nature of dividend payouts, it is of utmost importance that one considers both current yield and dividend growth. That is, in the dividend growth investment game, much like in golf or baseball, you’re looking for the sweet spot.

Source: High Yield Vs. Dividend Growth: Finding The Sweet Spot