Quantifying The Yield Vs. Growth Trade-Off

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Includes: AAPL, JNJ, KO, MCD, PEP, PG, T, TGT, WBA, WM
by: Eli Inkrot

Imagine for the next 5 minutes that your investment plan is solely concerned with your future income. Perhaps you currently entertain a dividend growth strategy, focusing on an ever increasing stream of payouts rather than on what other people (the market consensus) may or may not be willing to pay for your holdings. Or maybe you simply boast about a group of dividend paying stocks and happily concede that future capital gains, especially in the short-term, are beyond one's forecasting capability. The precise method by which you momentarily focus on future income isn't especially important.

Now that we are focusing on future income, I want you to choose between three options: a 2.5% current yield that grows at 15% annually, a 3.5% current yield that grows at 9% every year or a 5% current yield that grows at 3%? Ready, go.

Surveying the field, I would imagine that there's some initial hesitation. Questions, justifiably, should be raised. For example: what's the timeframe, the underlying securities and likelihoods of the given scenarios? Given a 1-year time frame and equal probabilities, only a fool would venture away from the 5% yield. On the other hand, given a 100-year time horizon, the math dictates that the 2.5% yield is the considerable run-away choice. For that matter, assigning 50/50 odds of no payouts at all for the 2.5 and 5 percent yields forces the 3.5% yield to the forefront.

The overarching point is twofold. First, one must be very specific about what the end goals might be. More than that, an investor must allow for the given strategy to appreciate. Considering one's self a long-term investor and acting the part of a day-trader will quickly erode a perfectly viable strategy. Second, no investment (no matter how spectacular) can be compared in isolation. The applicable alternatives must be weighed. So what exactly should one be considering when concerned with future income?

Time

This is obvious in importance, but not necessarily in application. In practice your decisions are apt to be more difficult than deciding if your investment horizon is 1-year or 100-years. I would argue that everyone has a long-term time horizon, but deciding between say 10 years and 12 years or 25 years and 27 years would give anyone a true challenge. Allow us to work through an example to better illustrate this point. Imagine that you have $10,000 to invest for the next 10 years. Given a variety of current yields and perceived dividend growth rates, one might be interested in the income that would be provided in year 11. Here's a table to summarize some calculations one might perform:

11th year Dividend Income on $10k Growth
Yield 3% 5% 7% 9% 11% 13% 15%
2% $326.00 $393.00 $473.00 $568.00 $679.00 $809.00 $961.00
2.50% $427.00 $515.00 $620.00 $742.00 $887.00 $1,056.00 $1,254.00
3.00% $537.00 $648.00 $778.00 $932.00 $1,112.00 $1,323.00 $1,570.00
3.50% $657.00 $791.00 $950.00 $1,137.00 $1,356.00 $1,612.00 $1,911.00
4.00% $787.00 $947.00 $1,136.00 $1,358.00 $1,618.00 $1,923.00 $2,278.00
4.50% $927.00 $1,115.00 $1,336.00 $1,597.00 $1,901.00 $2,257.00 $2,672.00
5.00% $1,079.00 $1,297.00 $1,553.00 $1,854.00 $2,206.00 $2,617.00 $3,096.00
5.50% $1,244.00 $1,493.00 $1,786.00 $2,130.00 $2,533.00 $3,003.00 $3,550.00
Click to enlarge

Note that the y-axis contains varying degrees of yield, while the x-axis highlights varying degrees of dividend growth. Additionally, it is assumed that the first 10 years of payouts are reinvested at the same yield rate and the dividends are growing constantly without volatility. In reality one would be concerned with both aspects, but for illustrative purposes this table works well. Notice that the values for the scenarios we outlined earlier are respectively: $1,254, $1,137 and $1,079. That is, one who is concerned with future income in the 11th year moving forward would likely be better off going with the 2.5% current yield and 15% dividend growth rate.

Additionally, notice the $932 number quoted within the 3% yield and 9% growth field. This is a reasonable benchmark for such well-known dividend growth companies like Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP) and Procter & Gamble (NYSE:PG). It is important to note that the above table is predicated on the long-term future income after a 10-year period. If instead one is only concerned with total income within a 10-year period, the table would look more like this:

10-Year Cumulative Dividends Growth
Yield 3% 5% 7% 9% 11% 13% 15%
2% $2,293 $2,516 $2,763 $3,039 $3,344 $3,684 $4,061
2.50% $2,866 $3,144 $3,454 $3,798 $4,181 $4,605 $5,076
3.00% $3,429 $3,773 $4,145 $4,558 $5,017 $5,526 $6,091
3.50% $4,012 $4,402 $4,836 $5,318 $5,853 $6,447 $7,106
4.00% $4,586 $5,031 $5,527 $6,077 $6,689 $7,368 $8,121
4.50% $5,159 $5,660 $6,217 $6,837 $7,525 $8,289 $9,137
5.00% $5,732 $6,289 $6,908 $7,596 $8,361 $9,210 $10,152
5.50% $6,305 $6,918 $7,599 $8,356 $9,197 $10,131 $11,167
Click to enlarge

Note that this time the dividends are not reinvested, but instead cumulated. It's interesting to see that the preferences are directly reversed. That is, for the person concerned only with future income over a 10-year period, the 5% current yield and 3% growth rate is a more profitable endeavor than 2.5% yield growing at 15%, despite its higher income in the latter years. Time value of money calculations are ignored here, but would not significantly effect the lasting implication. The realization is that while we understand that time is specifically important to consider, a more reasonable concern is one's own unambiguous ultimate goal.

Accuracy of Forecasts

It is paramount to consider that all views into the future are foggy at best. Walgreen (WAG) has increased its dividend by an average annual clip of 18.9% over the last decade while McDonald's (NYSE:MCD) averaged an ever impressive 27.4% annual dividend growth rate over the last 10 years; but that doesn't tell you anything about their growth rates in the future. Now keep in mind WAG's 37 straight years of dividend increases and MCD's 35 year record do suggest a lasting commitment to increasing shareholder value. However, little insight is provided as to whether or not future increases are in the 5-10% range or the stratospheric 15-25% range. In this way, it might be helpful to build in a "margin of safety."

Consider forecasting MCD's 3% current yield to grow at say 10% over the next decade rather than the loftier 20%+. Perhaps you're concerned about the 9-year dividend increase streak of Waste Management (NYSE:WM) growing at its average 5-year rate of around 9%, so you decide to go with 6% moving forward. The point, much like the time section, is to carefully consider how you are reaching your end goal. If your investment strategy is contingent on your dividends growing at 20% over a long time horizon, you might be in for a poor awakening. If, on the other hand, you happen to strategize around say 6% dividend growth and your holdings turn in an average yearly rate of 9%, then of course you would be pleasantly surprised. Be humble in your predictions.

Sustainability

The worst fear for an investor focused solely on future income is a dividend freeze or cut. In this manner, it is of the utmost importance to ensure two things: first, the companies one partners with have a long standing commitment to return cash to shareholdings. I do not question the swelling incomes that many early Apple (NASDAQ:AAPL) investors might be currently enjoying due to the recent start of a dividend program. But as we discovered in the last section, predictions are difficult. In this way, if I am focusing on future income only, I would rather own a collection of companies that have a storied record of increasing payouts, rather than companies that may or may not have this same focus in the future. Second, if I want the dividend to grow, it needs to be sustainable.

So what exactly makes a growing dividend sustainable? While many things should be considered, ability and earnings power are likely to be two of the most agreed upon criterion. Let's go back to our original question: would you rather have a 2.5% yield growing at 15%, a 3.5% yield growing at 9% or a 5% yield growing at 3%? Thus far we have covered the importance of knowing one's timeframe and examining the necessity to understate one's predictive ability. But we have not yet discussed the underlying securities. Instead of comparing yields, perhaps we can rephrase the question in a different manner: focusing solely on future income, would you rather own Target (NYSE:TGT), Johnson & Johnson (NYSE:JNJ) or AT&T (NYSE:T)?

It's basically the same question as before, but to me this clarification enhances the quality of our choices. Let's quickly examine our starting points.

Target - Target currently yields around 2.3% and has increased its dividend for 45 straight years. Over the last decade these increases have come in the form of a yearly average rate of about 17.5%. Furthermore, TGT has a payout ratio around 33%. Suggestng future increases would be a breeze. Based upon Target's 2017 goal of a $3 dividend and $8 in EPS, a 15% mid-term dividend growth rate and the possibility to double your investment in half a decade doesn't seem like too big of a stretch.

Johnson & Johnson - JNJ yields around 3.6% and has increased its dividend for 50 consecutive years. Over the past decade these increases have come in the way of an average annual growth rate of about 12% a year. While the current payout ratio is likely to be quoted in the 70% range in your sources, this can be a bit deceiving on a forward basis. For example, based on next year's $5.46 EPS consensus, the payout ratio quickly drops below 50%.

AT&T - AT&T currently yields around 4.8% and has increased its dividend for the last 28 years. Over the past decade, the payout has increased by an average rate of about 5%. Much like JNJ, the current payout ratio is a bit convoluted. I would caution that just over a year ago I did nothing that spectacular to pick up shares with in initial yield over 6%. Today, it's the same company with the same dividend growth prospects, but my purchase would trounce today's purchase in the future income game. Price paid, while monumental for those concerned solely with capital appreciation, also has a fundamental place in focusing on income.

Now, deciding between these three options is likely much more difficult than simply deciding between the yields of 2.5, 3.5 and 5%. However, given that each company looks relatively competitive with regard to willingness and sustainability, it shouldn't be. A short-term income focused time horizon necessitates T as a choice over JNJ and TGT. A longer-term time horizon looks to TGT. In any event, holding all three plus a collection of say 20-30 more with similar characteristics seems like a prudent way to go.

The lasting emphasis is that there are a variety of obstacles in finding one's personal yield vs. growth sweet spot. To this point, one should make it perfectly clear as to both what their time horizon is along with the corresponding goals they have for that period. With regard to predictions, understand that the best you can do is to make reasonable yet understated assumptions moving forward. Finally, there is no sure fire way to determine whether or not a dividend is sustainable. But hedging your bets and searching for the highest quality companies is likely a worthwhile tactic. The absolute criterion isn't particularly important, but the suitability of the applicable math is apt to be quite valuable.

Disclosure: I am long PEP, WAG, JNJ, PG, WM, KO, T, MCD, TGT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.