The stock market continues to rally, which is lowering dividend yields and making it harder to find good value. This has some investors scrambling for yield and buying the stocks of companies that have yields larger than those of treasuries. But investors can make a mistake if they are only looking at the dividend yield and not taking into account how the growth rate of the dividend impacts the overall total return through time.
A good case study in this area is Exelon Corporation (EXC). With a dividend yield of 3.9% and a relatively low payout ratio, some will jump right on it thinking this a good long-term investment. But a closer look at its recent dividend history should give investors pause.
Exelon Corporation, a utility services holding company, engages in the generation of electricity in the United States. It generates electricity from nuclear, fossil, hydro and renewable energy sources. The company is also involved in wholesale energy marketing business; and purchasing and retailing electricity and natural gas, as well as in the provision of transmission and distribution services.
*Profile taken from Yahoo Finance.
1 Yr Div
Annualized 5 Yr Div
Last Year Dividend Was Cut
Exelon Corporation is not in a growth phase. Its earnings per share over the past year fell by 3% and over the past three years have fallen by 2.9% at an annual rate. This helps explain the low dividend growth rates it has been having.
It is not necessarily obvious how investors will fare if they hold onto EXC for the next 10 years. They will receive a relatively high dividend, if it is not cut, but what if there is very little to no growth in dividend payments? It's important to analyze scenarios for such a company where we look at the dividend yield and growing dividends. I ran the following scenario on our publicly available calculator called Total Returns- Dividends Vs. Price Appreciation. If we buy 1,000 shares today, apply a dividend growth rate of 0% over the next 10 years, reinvest dividends, and assume the price of the stock does not change, we get the following:
The annual return in this case is 3.9%. I've also included the future value of the dividend income stream compared with the future value of the initial investment.
Remember that we assumed a dividend growth rate of 0%. How would that compare with a lower dividend-yielding stock, such as Johnson & Johnson (JNJ), that has a yield of 3.5% but has seen a dividend growth rate closer to 7%? Running the same analysis we find the following:
Over longer periods of time, companies that have consistently strong dividend growth tend to beat those that might have a higher dividend yield, but very little in the way of growth. That is why I like to focus on companies with a solid history of strong dividend growth when investing for retirement.
Dividend growth stocks can help a retirement plan immensely, especially vs. low-yielding treasury bonds. I plugged in the 4.7% total return figure I found above for a portfolio into our retirement planner in place of the 10 treasury bonds that were there before.
I found that if a typical 55-year old couple with $400,000 in assets moves 50% of their funds from treasuries to dividend payers that give them a 4.7% return, over 10 years they will have increased the time that their funds last in retirement by over 10 years.
Over a shorter period of time, Exelon could be a nice investment that pays a solid dividend. But for the long-run, I believe there are better options out there.
Scenarios such as the ones I've run here can help investors understand the power of dividends over time, especially when those dividends are growing.
Disclosure: I am long JNJ.