In the world of ultra-low interest rates in which we find ourselves today, many investors are drawn to dividend stocks that offer above-average yields. But dividend yields are only half the story, and the future rate of dividend growth is equally important. If the goal is to build a stream of dividend income then a balance needs to be found between yield and growth that gives investors the best results.
Walgreen (WAG, Financial) has a yield of 2.25%,General Electric (GE, Financial) has a yield of 3.25%, and Intel (INTC, Financial) has a yield of 4.15%, for example. But how do you determine what kind of dividend growth is necessary, given the yield?
Finding a balance
If you buy shares of the above three stocks and hold them for ten years, clearly the lower the yield the higher the dividend growth needs to be for the dividend streams from each stock to be roughly equal after the tenth year. But there's another complication: if dividends are reinvested then the higher-yielding stocks will allow you to add more shares over the ten year period than the lower-yielding stocks. So there are two different effects - the dividend growth rate and the reinvestment of dividends - which must be considered.
What's your goal?
The dividend stocks which you choose also depend on what goal you have. Imagine that you buy $10,000 worth of each of the three stocks mentioned above, and your goal is that after holding the stocks for 10 years and reinvesting the dividends the yield-on-cost is at least 10% for each stock. Yield-on-cost is simply the current dividend divided by your initial cost basis, so as the dividend grows and is reinvested this value increases. In this case, with a $10,000 initial investment, you would need to be collecting $1,000 annually from each stock to meet this goal.
Obviously, if you don't reinvest the dividends it's easy to determine the dividend growth rate required to reach the goal. For example, Walgreen, with a current yield of 2.25%, would need to grow its dividend by a factor of 4.44 over ten years, or about 16% annualized. But by reinvesting the dividends this required growth rate can be reduced considerably.
A picture is worth a thousand words
Walgreen, which has a 2.25% yield, would require about 16% dividend growth to achieve our goal if dividends are not reinvested, but only 14.7% dividend growth if dividends are reinvested. The average analyst estimate for annual earnings growth over the next five years is 12.88%, so at least some of the future dividend growth needs to come from an expansion of the payout ratio, which is currently around 30% of the free cash flow. Because the yield is so low reinvesting the dividends doesn't have as big an impact as it would for a higher-yielding stock, but it does make Walgreen more attractive as a dividend stock.
General Electric, which sits in the middle of these three stocks with a dividend yield of 3.25%, would need to grow its dividend by 11.9% annually if dividends are not reinvested, compared to 9.5% if dividends are reinvested, to meet our goal. This is important for GE because the average analyst estimate for earnings growth is 11.17%, right in the middle of these two values. In this case, reinvesting the dividends allows you to accept lower dividend growth and still reach your goal. And with a 3.25% yield the difference between the two scenarios is sizable.
Intel, with a 4.15% yield, has the biggest dividend of the three. If dividends are not reinvested then dividend growth must hit 9.2% annually for our goal to be reached. If dividends are reinvested, however, this growth only needs to be 6.2%. Intel's high yield makes dividend reinvestment particularly attractive, as it greatly reduces the necessary dividend growth needed in order to reach our 10% yield-on-cost goal. Although the average analyst estimate for earnings growth over the next 5 years is 12.33%, the uncertainty surrounding the future of the PC market and Intel's lack of market position in the mobile market makes this number seem dubious. But by reinvesting the dividends you can greatly lower the bar, making the stock much more attractive.
The bottom line
There are two avenues to dividend growth: the company actually increasing the dividend and the investor reinvesting that dividend. By taking advantage of the latter an investor can greatly reduce the minimum dividend growth rate needed to reach their goals, especially with higher-yielding stocks like Intel. The method used there was different than here, and it also didn't take into account reinvested dividends. Both calculations are rough, and different goals will change the numbers, so neither are to be taken as gospel. But this method clearly shows the benefits of reinvesting dividends, which can give a real boost to any dividend growth portfolio.
