My goal for this article and podcast is to convince you that a higher dividend yield does not always make for the best investment. Rather, one should look at the historical growth of the dividend and evaluate the likely future growth as well.
This is no academic exercise. Lack of growth can be the difference between a carefree retirement and one fraught with ongoing financial crisis.
Retirement Case Study
Imagine you’ve just retired. You’re 65 and planning for a 30-year retirement. You have $1 million in retirement accounts, and you plan to follow the 4% rule. That is, you’re going to withdraw 4% in year one and increase the amount each year by the rate of inflation.
In year one you’ll withdrawal $40,000 from your retirement accounts (4% of $1 million). You have an investment that so happens to pay a yield of exactly 4%. While there is no growth in the interest or dividends, 4% matches your withdrawal strategy, so it seems perfect. And it is in year one.
But what happens in year two? There is no growth in this investment so you get your $40,00 again in interest and dividends. That seems fine until you factor in inflation. If we assume an inflation rate of 2%, in year two you’ll need $40,800 just to maintain the same purchasing power you had in year one.
Now we start to see a problem with our no growth investment. It’s not going to pay us $40,800. It’s only going to pay us $40,000 a year. So what do we do? We have two choices:
1. Stick with the $40,000: We could decide to ignore inflation and continue living on $40,000. This may be a reasonable option for a few years. We just cut back on some expenses. But over a 30-year retirement, this approach is untenable. Assuming a 2% inflation rate, by the end of 30 years we’ll need over $72,000 to buy what $40,000 gets us today.
If we adjust our inflation assumptions, things only get worse. At 2.5% inflation, we need $84,000 in year 30. At 3% we need $97,000. Regardless of your view of inflation, eventually $40,000 won’t meet our retirement needs.
2. Start drawing down the principle: Since We have $1 million invested, we could spend not only the interest and dividends generated, but also some of the $1 million. Of course, as we draw down our nest egg, we also reduce our future interest and dividends of our no growth investment. Spending some of the principal in of itself wouldn’t be a problem if we enjoyed some growth in our $1 million portfolio. But remember that in this example our investment doesn’t grow in value. Chipping away the principal could eventually cause us to run out of money during retirement.
In other words, what seemed like a robust 4% dividend turned out to be not so great.
You may be thinking this example is silly. What investment has literally no growth? In a word–bonds. Invest in a 30-year treasury bond that you hold to maturity and your investment won’t grow a nickel. One million dollars invested today will be $1 million 30 years from now when the bond matures. And the interest payments are fixed, too.
Growth is critical.
Dividend Yield is Only Half the Story
When you’re investing for dividends, the dividend yield is an important consideration. But it is only half the story. We absolutely have to look at growth. With stocks, the higher yield is not always best. A lower yielding stock with more growth will often far outpace a higher yielding stock with minimal growth.
In this regard stocks and bonds behave different. With bonds and other fixed income investments, the higher the yield the better (assuming comparable credit risk). Comparing a certificate of deposit, for example, is simple. The CD with the highest yield wins. We don’t have to consider growth because there is no growth with a CD.
So with stocks and stock dividends, it’s not just the yield (yield = annual dividend amount / price), you also have to look at the growth in both the dividend itself and in the underlying value of the stock.
Calculating Dividend Growth
So how do you calculate dividend growth?
1. Based on actual dividends, not dividend yield
When talking about dividend growth, we’re talking about the actual amount of the annual dividend, not the dividend yield. Why? Remember the yield is not just a function of the dividend payment. It’s also a function of the price of the stock. In a stable market, as the dividend payments go up, the stock price often goes up as well. In this case, the yield wouldn’t change. A company that regularly increases in its dividend year after year after year can see its yield decline if its price rises faster than the dividend increase.
2. Morningstar as a great tool
Morningstar is a great free resource to get dividend information on a company or fund. It’s easy to find this data, and we’ll use Pepsi as an example. On the Morningstar site enter the stock’s ticker symbol in the quote box at the top (PEP in our example):
This takes you to the Overview page for Pepsi. From here, select the Key Ratios link:
From here you’ll see a row for annual dividend payouts. In the case of Pepsi, you’ll see payouts going back to 2004. You’ll also see the amounts grow form $0.85 in 2004 to $2.24 in 2013.
While it’s good to see a regularly increasing dividend payout, it’s difficult to gauge the actual growth. To do this I use a spreadsheet. Create a column for each year then calculate the increase going forward. Here’s a snapshot of the simple spreadsheet that I used to evaluate Pepsi (click image to enlarge it):
Here I’m looking at the percentage growth in the dividends and earnings per share. That is of course just the beginning. The next step is to ask why. Why is the dividend growing or not growing? Why are earnings per share growing nor not growing? Are they growing solely because of share buybacks? The list goes on.
4. Look at competitors
It’s also important to look at competitors. On the spreadsheet I showed you above there is also the same data for Coca-Cola. It’s important to compare competitors in terms of earnings per share and dividend growth. Why does one outperform the other? Why is one enjoy higher margins than the other? Does one have a competitive advantage, and if so, can it last?
In my case I invested in Pepsi over Coke for one simple reason–Pepsi tastes better! Ok, perhaps there was a little more to my analysis than that.
5. Payout Ratio (Dividends per share / Earnings per share)
Finally, we need to mindful of the payout ratio. The payout ratio is simply the annual dividend per share divided by the annual earnings per share. This ratio is an easy way to see how much of a company’s earnings are paid out in dividends.
Once again Morningstar provides this information:
Why is this important? There are several reasons.
First, you want to make sure that a company’s dividend growth is sustainable. A company may be increasing its dividend each not with increased earnings, but with a higher payout ratio. What may have started as a 50% ratio could over a number of years creep up to 60%, 70%, 80% or more. Eventually, the company is going to run out of earnings to pay out increased dividends.
Second, a low payout ratio could also be problematic. A payout ratio that’s too small could suggest that a company is not paying as much as they should in dividends. That in turn raises the question of what the company is doing with its cash. It may turn out that they are smartly reinvesting earnings back into the company. Then again, management could be going on an ego-driven buying spree of other companies. You have to dig into the company’s SEC filings, earnings calls and other information to find out.
Third, trends are important. Because there is no one “right” payout ratio, understanding the company’s historical payout ratio can help evaluate its current ratio. If the payout has changed significant, you’ll want to understand why.
Finally, look at the payout ratio of competitors. Different industries have different payout ratios. In industries with little growth opportunity, for example, you’ll likely see higher payout ratios. For example, American Electric Power Co Inc. (ticker: AEP) paid out 64.2% of its earnings last year (2013). Apple (ticker: AAPL) paid out 28.7%. Some say Apple should pay out even more (and buyback shares). Regardless, its growth prospects are sunnier than a utility company.
The key takeaways
The dividend yield itself is only half the story, at best. You have to look at the growth potential of the company as well. Indeed, a lower yielding stock with better growth prospects can be far more valuable than a higher yielding stock with limited growth potential.