All too often, dividend investors focus exclusively on dividend yield, when they should be giving even greater attention to dividend growth, explains Chuck Carlson, editor of DRIP Investor.
Indeed, the power of dividend growth in an investment program is evident in a number of ways:
- A growing dividend stream can boost your cash flow over time (if you are receiving those dividends in cash), helping you offset the ravages of inflation on your purchasing power.
- A growing dividend stream that’s reinvested allows you to take advantage of the magic of compounding in your investment program. Another angle on dividend growth that is often overlooked is that it can accelerate your payback on investment.
Let’s say you buy 100 shares of a $40 stock. Your investment is $4,000. And let’s say the stock pays a dividend of $0.80 per share (that’s a yield of 2%).
Based on that dividend, you expect to receive $80 in dividends the first year. If that dividend stream never changes, you will recoup your initial $4,000 investment in 50 years. I call that your payback.
Depending on your age, 50 years may actually be a legitimate holding period for your investments. Certainly, investors who entered the investment game as teenagers may be holding stocks for 50 years or more. Still, 50 years is a fairly long period of time to recoup an investment.
Now, what if that dividend stream grew just 6% per year instead of staying stagnant? You would recoup your initial $4,000 investment via dividend payments in roughly 24 years. And what if that dividend stream grew at 10% per year? Your payback period drops to just 19 years.
Now, I’m not suggesting that price appreciation doesn’t matter. In fact, ultimately, it is a stock’s total return—price appreciation plus dividend return—that matters most when selecting stocks.
Sure, it’s great to have a stock pay back your initial investment in just 15 years, but it’s a whole lot better to own a stock that increased your initial investment fivefold in 15 years through price gains and dividend increases.
Still, using dividend payback is a worthwhile concept for framing the risk-return potential of two stocks. It’s also a useful tie-breaker when choosing between two investments.
The table below provides a matrix to help you determine payback times based on dividend yields and dividend-growth assumptions. The table is helpful for framing the power of dividend growth versus yield.
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For example, a stock that yields 2% and boosts its dividend 10% per year has the same payback period (19 years) as a stock yielding twice as much (4%) but where dividend growth is only 3% per year.
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