The high dividend growth vs high yield debate raises an important question. Which are the better dividend paying stocks - stocks with a lower initial yield but with a high dividend growth rate, or stocks with a low dividend growth rate but with a higher initial yield?
To address these issues - I don't believe a clear cut, irrefutable answer is actually possible - let's first make some mathematical comparisons and then follow up with a short discussion of related issues.
To begin, let's compare a couple of scenarios.
Stock A is a classic dividend growth candidate.. Let's say that it provides an initial 3% dividend yield and that dividend grows at a rate of 10% each year. Let's also assume that we reinvest those dividends, and that those reinvested funds are done so at a new 3% yield (which then grows 10% annually thereafter).
Stock B is a classic high yield stock. Let's say it's a REIT or an MLP. We'll assume the initial dividend yield here is 7% and that the dividend yield here grows by just 3% a year. Again, we'll reinvest our dividends and we'll assume we get a new 7% yield (which then grows at a 3% annual clip thereafter).
So which is the better investment? More specifically, which produces more income over time?
Most people would assume (rightly so) that Stock A with its much higher dividend growth rate would eventually outgrow the dividends produced by the slower growing Stock B. This is definitely the case made by traditional dividend growth advocates.
But the intriguing part hinges on the word eventually. How quickly would the lower yielding, higher dividend growth company overtake the higher yielder, lower dividend growth company?
Let's take a look at the table below (and assume a $10,000 initial investment):
In the example above, it would take between 30-35 years (Year 33 actually) before the total dividend income from reinvested Stock A would finally surpass the total dividend income from reinvested Stock B.
Make Your Own Reinvested Dividend Calculator -
Warning: Good luck finding an online calculator that provides the numbers in the table above.
It's easy to figure out the returns of a straight compounded rate. It's easy to calculate dividend income based on a dividend growth rate as long as those dividends are not reinvested. And it's easy to determine total dividend income on reinvested dividends as long as there is never any dividend growth.
But how do you go about calculating the income from both dividend growth (on existing shares) and reinvested dividends (at "new money" rates)?
There are actually two methods:
Method #1 - The Pain in the Ass Way to Estimate Total Annual Income on Growing and Reinvested Dividends
You'll need a spreadsheet for this one, and one that's as wide as it is long. Basically, you start with the dividends received from your initial investment and then increase those each year by your dividend growth rate.
Then you have to take the preceding year's dividends (which are reinvested into additional shares) and calculate the amount of dividends those would produce (presumably back at the initial rate). The dividends produced there would then begin to grow at the dividend growth rate in the years that followed.
But each year you would have to separate the dividends received from the year before and "restart" those at the initial yield and then "grow" them by the dividend growth rate each subsequent year.
See? A real pain in the ass.
But once you actually do this, you make a startling mathematical discovery - simply take the total number of dividends received in any given year and subtract the previous year's dividends to determine the total increase in income.
Divide that figure by the previous year's income to determine how much your income grew year over year.
Guess what? As long as the initial yield and the dividend growth rate remain constant, your overall annual income will increase at the same rate each year.
Which naturally leads us to . . .
Method #2 - The 1 Second Approach to Estimating Total Annual Income on Growing and Reinvested Dividends
This is super easy - based on the mathematical insight above, in order to determine your long term total annual dividend income growth rate, you simply take the annual dividend growth rate and add the "new" initial dividend yield of the repurchased shares.
So in our examples above:
Stock A - 3% Initial Yield + 10% Growth = 13% Annual Compounded Income Rate
Stock B - 7% Initial Yield + 3% Growth = 10% Annual Compounded Income Rate
Once you understand how to easily calculate the long term total income growth rates based on the dividend growth rate and the initial yield of reinvested dividends, it makes it much easier to compare these two types of dividend stock scenarios.
And comparing is necessary since, obviously, there's going to be some fluctuation involved in the numbers.
What if you have a slower dividend growth rate on the 3% yielding stock? What if the "high yield" stock is in the 6-6.5% range instead of 7%? What if it's higher? What if you're looking at a higher yielding preferred stock where there's no dividend growth at all?
The takeaway is this:
The higher the yield on the high yield stock, the greater the head start the high yield stock will have. But the higher the dividend growth rate of the lower yielding stock, the quicker it can catch up.
I do need to point this out - successful dividend investing is more than just a numbers game. The biggest danger income investors face is being seduced by high yielding but low quality companies.
In my opinion, there are basically 3 types of high yielding stocks:
Sadly, there won't be any quality companies in the third category. There will only be unrealistic and unsustainable promises.
For additional insights into the high dividend growth vs high yield debate (discussion is probably a better word), check out these following resources:
KO - 100 shares
GIS - 25 shares
JNJ - 25 shares
PAYX - 25 shares
TGT - 50 shares
Open Market Purchase Price: $11,195.23
Less Booked Option Income: $6235.40
Tot. Discount: 55.70%
Adj. Div. Yield: 7.50%