Dividend Growth Rule of Thumb

Here is a rule of thumb about dividend growth. It helps us select investments for the Dividend Blend.

Dividend Growth Mathematics

At a constant growth rate, the dividend amount equals the initial dividend amount times (1+the growth rate)^(the number of years).

We are most interested in dividend growth that takes place during the first decade.

A dividend amount that starts at 3% initial dividend yield and grows by 10% per year grows to 7.78% of the initial balance after ten years. Over the same ten year time period, an investment that starts at a 4% initial dividend yield grows to 7.78% of the initial balance at year 10 if it grows by 6.88% per year. For an initial yield of 5%, the required growth rate is 4.52% per year.

Inflation affects all of these calculations identically. In terms of real growth, the 3% initial yield grows to 3% times [(1+the growth rate)/(1+inflation)]^(the number of years). At 10% per year, 3% inflation and 10 years, the amount increases by a factor of 1.930 to an inflation adjusted yield equal to 5.790% of the initial balance.

Notice that the Gordon Equation does NOT apply. That is, the required initial yield plus the dividend growth rates differ at Year 10.

The following produce equal income streams at Year 10:

a) 3% initial dividend yield plus 10.00% per year dividend growth rate.
b) 4% initial dividend yield plus 6.88% per year dividend growth rate.
c) 5% initial dividend yield plus 4.52% per year dividend growth rate.

The following are the sums of initial yields plus dividend growth rates.

a) at 3% initial dividend yield, the sum is 13.00%.
b) at 4% initial dividend yield, the sum is 10.88%.
c) at 5% initial dividend yield, the sum is 9.52%.

In addition, a higher yield produces a higher total income during the first decade.

The Dividend Blend

The Dividend Blend consists of an investment with a high initial yield and another investment with a high dividend growth rate. You never sell any shares. The fast growing investment eventually takes over and supplies a continuing income that grows faster than inflation. Income from the high yielding investment fills the income gap during the first few years. You reinvest any income higher than the withdrawal rate during the early years.

A simple 50%-50% allocation typically allows for withdrawals of at least 5% (plus inflation).

You withdraw 5% of your initial investment (plus inflation) each year. You take your withdrawals strictly from the income stream. You reinvest any surplus. You never sell any shares.

You increase withdrawals around Year 10.

Rule of Thumb

I have found that an investment with a 3% initial yield with a 10% per year dividend growth rate is satisfactory for a dividend blend. This is roughly equivalent to an investment with a 4% initial dividend yield with a 7% per year growth rate. Or an investment with a 5% initial yield and a 4.5% per year growth rate.

In addition, continuing withdrawal rates can safely exceed 5% of the original balance (plus inflation) by optimizing allocations.

Have fun.

John Walter Russell
September 25, 2007