Initial Yield versus Dividend Growth

I have compared several combinations of the initial dividend yield and dividend growth rate while keeping their sum (the Investment Return) constant. In terms of generating an income stream, starting with a higher yield is better.

Closer examination reveals that a faster growth rate necessarily leads to capital appreciation. This clouds the issue. There is no clear cut winner.

This Investigation

The Investment Return equals the sum of the initial dividend yield and the dividend growth rate (annualized). The Speculative Return is the gain or loss (annualized) caused by changes of multiples, that is, how much the market pays of $1 of dividends. To a reasonable approximation, in the long term, the Total Return (as an annualized percentage) equals the sum of the Investment Return and the Speculative Return.

This approximation does not tell you what happens before reaching the long term. Clearly, a higher initial dividend yield produces a larger income stream in the early years. In time, an investment with a faster growing dividend will catch up. Then it will start paying more.

In this investigation, I looked at only the income stream. I ignored the Speculative Return. I assumed that the relationship between the price and the dividend yield remains constant, that the dividend growth rate remains constant and that inflation remains constant (at 3%). In all cases, I started at $10000. I looked at Investment Returns of 10% and 8% (nominal).

Results at 10% Investment Return

Initial balance=$10000.
Inflation=3%.
SUM (initial dividend yield + nominal dividend growth rate)=10%.

ORDER: Initial dividend yield = 3%, 4%, 5%, 6%, 7%.
Nominal dividend growth rate (annualized) = 7% per year, 6% per year, 5% per year, 4% per year and 3% per year, respectively.

Year 10:
Nominal
Dividend Income: 784 versus 1058 versus 1324 versus 1577 versus 1811.
Price: 15006 versus 16711 versus 18396 versus 20043 versus 21634.
Real
Dividend Income: 584 versus 787 versus 985 versus 1173 versus 1347.
Price: 11166 versus 12434 versus 13689 versus 14914 versus 16098.

Year 20:
Nominal
Dividend Income: 3213 versus 4443 versus 5468 versus 6192 versus 6584.
Price: 32825 versus 41151 versus 48744 versus 55176 versus 60227.
Real
Dividend Income: 1779 versus 2460 versus 3027 versus 3428 versus 3646.
Price: 18174 versus 22784 versus 26988 versus 30550 versus 33346.

Year 30:
Nominal
Dividend Income: 25466 versus 34860 versus 38854 versus 37614 versus 32992.
Price: 144783 versus 195703 versus 227643 versus 238632 versus 232996.
Real
Dividend Income: 10492 versus 14362 versus 16007 versus 15497 versus 13592.
Price: 59649 versus 80627 versus 93786 versus 98313 versus 95991.

Year 35:
Nominal
Dividend Income: 106945 versus 139089 versus 138106 versus 115136 versus 85712.
Price: 464211 versus 618638 versus 663887 versus 620873 versus 533918.
Real
Dividend Income: 38007 versus 49430 versus 49080 versus 40917 versus 30461.
Price: 164973 versus 219854 versus 235934 versus 220648 versus 189745.

Year 40:Nominal
Dividend Income: 657498 versus 765114 versus 629967 versus 421607 versus 250382.
Price: 2223548 versus 2736345 versus 2509132 versus 1943752 versus 1379799.
Real
Dividend Income: 201560 versus 234551 versus 193121 versus 129246 versus 76756.
Price: 681644 versus 838845 versus 769192 versus 595870 versus 422987.

NOTE: Fast dividend growth shows up before it adds enough to shift the biggest balance. This explains the Year 35 mismatch.

Results at 8% Investment Return

Initial balance=$10000.
Inflation=3%.
SUM (initial dividend yield + nominal dividend growth rate)=8%.

ORDER:
Initial dividend yield = 2%, 3%, 4%, 5%, 6%.
Nominal dividend growth rate (annualized) = 6% per year, 5% per year, 4% per year, 3% per year and 2% per year, respectively.

Year 10:
Nominal
Dividend Income: 424 versus 644 versus 861 versus 1069 versus 1264.
Price: 12971 versus 14481 versus 15983 versus 17459 versus 18894.
Real
Dividend Income: 315 versus 479 versus 641 versus 796 versus 941.
Price: 9651 versus 10775 versus 11893 versus 12991 versus 14059.

Year 20:
Nominal
Dividend Income: 1174 versus 1852 versus 2468 versus 2955 versus 3281.
Price: 20567 versus 26285 versus 31753 versus 36663 versus 40819.
Real
Dividend Income: 650 versus 1026 versus 1366 versus 1636 versus 1817.
Price: 11388 versus 14554 versus 17581 versus 20299 versus 22600.

Year 30:
Nominal
Dividend Income: 4524 versus 7496 versus 9573 versus 10346 versus 9975.
Price: 46269 versus 68196 versus 86309 versus 98154 versus 103596.
Real
Dividend Income: 1864 versus 3088 versus 3944 versus 4263 versus 4110.
Price: 19062 versus 28096 versus 35558 versus 40438 versus 42680.

Year 35:
Nominal
Dividend Income: 10771 versus 18132 versus 21947 versus 21624 versus 18633.
Price: 85042 versus 133185 versus 166553 versus 179928 versus 177026.
Real
Dividend Income: 3828 versus 6444 versus 7800 versus 7685 versus 6622.
Price: 30223 versus 47332 versus 59190 versus 63943 versus 62912.

Year 40:
Nominal
Dividend Income: 30723 versus 51635 versus 57149 versus 49339 versus 36652.
Price: 189032 versus 308341 versus 366641 versus 360916 versus 318843.
Real
Dividend Income: 9418 versus 15829 versus 17519 versus 15125 versus 11236.
Price: 57949 versus 94524 versus 112396 versus 110641 versus 97743.

Initial Finding

It is best to start with a high yield. It isn’t until Year 30 that faster growth asserts itself.

A Closer Look

If you compare the size of the dividends at later times, something appears to be out of whack. What has happened is that, given enough time, dividend growth reaches unrealistic levels.

These calculations show what happens. They show what the dividend yields become after a period of growth.

Dividend growth at Year 10:
1.03^10=1.34 and 7% yield grows to 9.4%.
1.07^10=1.97 and 3% yield grows to 5.9%.

Dividend growth at Year 20:
1.03^20=1.81 and 7% yield grows to 12.6%.
1.07^20=3.87 and 3% yield grows to 11.6%.

Dividend growth at Year 30:
1.03^30=2.43 and 7% yield grows to 17.0%.
1.07^30=7.61 and 3% yield grows to 22.8%.

Dividend growth at Year 40:
1.03^40=3.26 and 7% yield grows to 22.8%.
1.07^40=14.97 and 3% yield grows to 44.9%.

Clearly, the price is not going to remain unaffected if a good company starts yielding 10% to 20% or more. Share prices will increase. Reinvested dividends will buy fewer shares.

The model breaks down between 10 and 20 years. It is difficult to project what happens after the first decade.

Summary

During the first decade or so, when Investment Returns are equal, it is better to start with a higher dividend yield.

Beyond this, the picture becomes cloudy. Dividend yields grow so much that there must be price appreciation beyond what I have modeled. This is likely to favor faster growing dividends.

Have fun.

John Walter Russell
February 25, 2007