In a previous article, we discussed some of the reasons why a value investor might consider building their portfolio around dividend stocks. Today, we will look at the ways in which analysts evaluate dividend plays; in particular, which metric gives a better assessment of income stock quality: current yield or dividend growth?
What is dividend yield?
Recall that dividend yield is simply the income returned by a stock via dividends, expressed as a percentage of that stock’s price. Accordingly, the yield can rise if the share price falls, or if the company in question increases its dividend payouts. Generally speaking, investments with sharply spiking yields are the result of the former. In these situations, a high yield signals a falling share price, which is of course not a sign of investor confidence. In the last piece, we talked briefly about why high yields can be dangerous -- they drain capital from the business and are symptomatic of poor management.
Additionally, you must consider not only what the yield is right now, but what the yield is likely to be in the future. Remember, dividend investing is typically a long-term strategy. A high yield today is not just a sign that the company itself might be in trouble. It also signifies that future dividends may be cut, leaving you with a lower effective return on your overall investment than you may have thought based on just the yield.
What is dividend growth and why is it superior to current yield?
The dividend growth rate is calculated as a percentage of the difference between dividends paid in one year and the next. So if a company pays out a dividend of $1.00 per share one year and $1.10 per share the next, then the dividend growth rate is 10%. Analysts also calculate the average annual growth rate, which over a long period of time can provide investors with a decent guideline for how much they can expect payouts to grow in the future. Of course, past returns do not always correlate with future performance, but in general a gradual increase in dividend payments over a long period of time is a sign of good stewardship.
Why is it important to look at dividend growth? A company that can consistently increase payouts to its shareholders at a reasonable and sustainable rate is also likely to be increasing its revenues and earnings, which is what we look for in any regular stock. This means that it is also likely to be increasing its market capitalization, which over time will lead to an increase in the value of the stock itself.
Summary
This strikes at the heart of why steady dividend growth matters. If you invest $50,000 in a high-yield stock that loses 30% of its value, it doesn’t matter whether it continues to pay out dividends at an unchanged rate -- the total value of your investment will have cratered by a significant amount. The truth of the matter is, most retail income investors do not solely live off dividends in retirement. More often than not they sell off parts of their portfolio to unlock some of that saved-up value. That portfolio will only have retained its value if the shares themselves have continued to appreciate. Better to invest in solid companies with moderate yields than to chase high yields that will not weather the bear markets.
Disclaimer: The author owns no stocks mentioned.
