Why you need to account for dividend growth

By: ispeculatornew
Date posted: 07.06.2010 (4:00 am) | Write a Comment  (6 Comments)

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Just a small clarification to start off. This post was first published in our IntelligentSpeculator free newsletter. We do not usually republish that material on here but received a lot of requests to add it on here. You might want to subscribe to our mailing list to get such information in the future, it is free:)

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As you can imagine, there is a major difference between a stock that yields a steady 3% dividend yield and one that pays 3% but is increasing the dividend every year. Over time, the gap between the two can become huge. The challenge however is how to value that difference. There is no right or wrong way to do it but here are some ideas.

Current Yield?

Investors often make the mistake of only looking at the current yield. That can be grossly misleading. Let’s take our YYY stock. When it was traded at 10$ and had a $0.50 dividend the stock was trading at a 5% dividend yield right?

Take that stock a few years later and it might be paying 1$ annually but the stock price might very well be 20$. That comes out to the exact same yield of course but in reality you prefer this stock over another one that would have stayed with a $0.50 dividend. Obviously! No we’re not even considering the gain on the stock here (which would make things even easier to analyze) but simply the dividend.

How to account for the growth?

When you look at the dividend yield, you could take other factors into consideration when filtering. For example, you could get the Dividend Yield but also the 2 year and 5 year expected yields. How?

Many companies are very predictable when it comes to dividend hikes. If you know that company YYY should hike its dividend to $0.60 in 2 years, the expected 2y yield would be 6%. What does that mean? It means that compared with your purchase price, the dividend will be paying 6% 2 years from now. These are projections of course but isn’t that what finance is anyway?

If stock YYY will be paying 1$ 5 years from now the “Expected 5Y. Yield would be 10%. At that point you will be happy to not have picked the steady dividend.

Again, in this post, the 5 year expected yield is NOT the yield you will make in the first 5 years but rather the yield you will be earning compared with your purchase price 5 years ago.

Of course, all of this assumes the stock price remains steady. In reality it could increase or decrease!

Here is a good example: Proctor & Gamble (PG)

What to avoid?

If there is one thing you want to avoid when building such a portfolio, it is investing in a company that either cannot maintain its current dividend growth or even worse, one that cannot even pay for its current dividend. Just look at GE’s dividend progression. No need to tell you that those who had expected a steady increase in dividends lost big time.

Here is a good example: General Electric (GE)

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6 Comments

  1. Comment by The Financial Blogger — July 6, 2010 @ 7:42 am

    I deeply regret not buying Canadian Banks when they were showing half of their stock value back in December 2008… I could have built a solid dividend portfolio with an average yield of 10%+!

  2. Comment by Craig — July 6, 2010 @ 8:43 am

    If you build a Dividend portfolio considering dividend growth. Can you, after several years, average a div yield over 5%?

    This could mean a great retirement pension plan! I wonder why investors don’t necessarily do it?

  3. Comment by John — July 6, 2010 @ 3:28 pm

    it seems too good to be true! how do you build a dividend growth portfolio? Thanks!

  4. Comment by IS — July 6, 2010 @ 6:44 pm

    @TFB – Hahah, it might not be too late, you never know right?:)

    @Craig – Yes, no doubt it is possible. It also depends of course if you are counting the current yield or yield on your average cost! Why investors don’t do it? Good question. No plans for most I’d say… but I will discuss this very soon!

    @John – Wait a few more hours and you will have the answer in a post on this blog;)

  5. Comment by evo34 — July 7, 2010 @ 2:33 am

    Why do people not realize that when a dividend is issued, the value of the company (its stock price) drops by the same amount. You cannot create “yield” out of thin air. Receiving yield is equivalent to selling that pct. of your position. Sure, you receive cash, but your remaining investment drops in value proportionally.

  6. Comment by IS — July 7, 2010 @ 6:15 am

    @evo34 – I do think that most investors realize the distinction. But I would say that dividends can be attractive for at least 2 reasons:

    -Historical data supports the theory that companies paying dividends have been more stable and generated better returns
    -Depending on each individual, taxation can be different for dividends and capital gains.

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