Dividend Growth

by Mr. Cheap

I used to wonder why anyone would buy Disney or Coca-Cola or any of the big name companies. Sure they were leaders in their fields and great companies and all that, but there stock price seemed pretty stead (with modest gains year-after-year) and it just seemed like GICs and more conservative investments could match them with zero risk (instead of the slight risk these companies seem to offer).

Even when I started getting into dividend stocks, I looked at the dividend-yield on these companies, and just couldn’t figure out why anyone would buy them (at 1% dividend-yield it still seemed like a savings account was a better bet).

What I was missing was the rate of the growth of the dividend. Sure Coca-Cola’s dividend might be 2.58% today, but given there 5 year dividend growth of 11.49%, means the dividend should be 4.4% in 5 years and 7.6% in 10 years, 13.2% in 15. Along with that dramatically increase dividend-yield (relative to our original purchase price) will be the new dramatically higher price for the stock to support the higher yield. Rob Carrick and Tom Connolley make a very convincing case that over the long term these high-growth dividend stock prices will keep shooting up, supported by the ever increasing dividends. A retirement income that increases by 11.49% per year is exciting both from a “easily fend off inflation” perspective as well as a “no worries about running out of money” perspective.

Consider instead a stock that pays a high yield, but which doesn’t increase. You’d be happy receiving the higher amounts in the first years, but when a growth stock overtaxes the yield and keeps going you then might become a little less happy.

I’m convinced there’s some way to factor in the current yield and the growth yield to figure out which is a better buy, but am somewhat at a loss how to calculate this. One idea I had is to get a “short list” of companies I like, which are all blue chip, long term increasing dividend payers. Sort the list in order of the 5 year dividend growth and throw away the bottom half. Then rank the remainders in terms of dividend-yield and examine the first few companies as potential “buys”. Repeat when funds allow.

Alternatively, you could only look at the top half of the current yield, then examine the first few when you order for growth. I’m not sure how much weight should be given to each element of a stocks history if you wanted to order them taking both ratios into account (naively I’d guess 50/50). Define “dividend strength” as yield x growth and rank. Start at the top and look for good buys.

There’s probably a mistake in this overly-simplistic approach, if any readers know better than I do (and have been good enough to read this far), I’d love to have my error pointed out in the comments!

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{ 1 comment… read it below or add one }

1 Yesudeep Mangalapilly

If the 10 year treasury yields 2.9%, it doesn’t make sense to buy something that starts the yield at less than that. Yes, your yield on cost 5 years from now may be very high, but the first rule of investing is “Don’t lose money” and the second rule of investing is “Refer to rule #1.” A starting yield of less than the treasury yield implies a few years of loss depending on how fast the yield grows. You want a margin of safety over that base treasury yield before you even consider the yield growth rate. One has to ask 3 questions before investing a bird in hand: 1. how many birds are in the bush? 2. how sure are you? 3. when will you get them? (quoting Mr. Buffett).

1. how many birds are in the bush: yield and yield on cost.
2. when will you get them? 5 years? 10 years? 20 years?
3. how sure are you? does this business cost more to operate than it yields? does it have a moat? does it have a history of steady cash flow?

Looking for just a dividend yielding stock is not enough. The stock must behave like an equity bond as well.

That’s what I’d like to add.

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