DGI Lesson 18: High Yield or Fast Growth?

The Issue

Some dividend growth investors believe that a fast-growth stock is “better” than a slower-growing stock. Others would say that high yield is more important than dividend growth rate.

For example, some would consider Starbucks (SBUX) to be better than AT&T (T), because Starbucks has a much faster rate of dividend growth.

Its dividend growth rate over the past 5 years has been more than 30% per year.

Others would say that AT&T is better, because it has a much higher yield.

Its yield is over 4.5%.

(I have written about both of these companies as Dividend Growth Stocks of the Month: Starbucks here and AT&T here and here.)

But does either characteristic, by itself, make Starbucks or AT&T “better”?

It depends. “Better” is subjective. Whether a high-growth or high-yield stock is better for you depends on a multitude of factors, including your own goals and situation in life.

Analysis

To get started, let’s look at the math. Here is the tale of the tape for these two stocks.

captureThe last three factors are tied. Both stocks’ valuations are OK and their dividends are safe.

So it comes down to yield and growth rate. And, as we will see, the perils of prediction.

In evaluating stocks, sometimes it can be tempting to gloss over yield in favor of dividend growth rate, or vice versa. But to decide what’s “better,” you have to look at both, particularly how they play out over time.

To illustrate the interplay between yield and dividend growth rate, I like to use the calculator at Miller/Howard Investments. Let’s plug Starbucks’ and AT&T’s stats into the calculator and see what we get.

Here is Starbucks, showing scenarios both with and without dividends reinvested:

captureI plugged in Starbucks’ 1.5% yield and the maximum 20% per year growth rate for both versions. For the orange inputs, I had the dividends reinvested (note the checkmark in the box). The blue version does not reinvest dividends. The calculator requires a $10,000 initial investment, so the numbers are scaled to that amount.

So both graphs represent Starbucks – with dividends not reinvested (blue) and with dividends reinvested (orange). As you would expect, the orange version with dividends reinvested pulls away from the blue version, especially after Year 15 or so.

How do these results compare with AT&T? To make the comparison, we will focus on the version with dividends reinvested, since this is what most investors do before they retire and need the income for expenses.

So in the next graph, I will plug AT&T’s stats into the blue input area, with dividends reinvested. Starbucks remains the orange stock, also with dividends reinvested.

captureAt a glance, this looks like a laughable mismatch.

But look closer. Through the first 9 years, AT&T sends you more dividends than Starbucks every year. Here are the dividends by year.

captureAT&T starts out with a sizable advantage. While Starbucks is growing its payout much faster, AT&T’s annual payout begins much higher and is more than Starbucks’ payout in each of the first 9 years.

The degree of AT&T’s advantage, of course, declines each year, because Starbucks’ dividend is growing much faster.

But that’s what AT&T’s higher yield gets you right off the bat: More dividends for the first 9 years.

Starbucks finally passes AT&T in Year 10 by $2 ($866 to $864). Then the gap widens in Starbucks’ favor each year.

But by the 10-year crossover point for Starbucks to pass AT&T in annual dividends, AT&T has amassed a huge lead in total dividends paid.

After 9 years, the total dividends paid are $5630 for AT&T vs. $3327 for Starbucks. AT&T has paid out 69% more dividends than Starbucks through the first 9 years.

It will take another 6 years for Starbucks to catch up in terms of total (cumulative) dividends delivered. Here is the rest of the table illustrating that.

captureSo Starbucks’ higher growth does eventually win out in both dividends per year (Year 10) and cumulative dividends (Year 15).

I have compared numerous pairs of stocks. Crossover points of 10-12 years for annual dividends, and 17-18 years for cumulative dividends, are typical when comparing a high-yield stock to a high-growth stock.

Those are significant chunks of an investor’s lifetime. What you term “better” may thus have something to do with your age when you start, and/or your need for immediate income. A retiree may view the question quite differently from a 30-year-old.

Dividend Growth Predictability

There’s another factor to think about: What is the chance that Starbucks will maintain a DGR of 20% per year for 20 years or more?

Let’s just put it this way. It hasn’t been done yet. According to the excellent Tesselation website, no company with a DGR as high as 20% per year has maintained it for at least 7 years, let alone 20.

The highest DGR that has been maintained for at least 20 years is 9% per year, and only 1 company has done it.

That company is Ross Stores (ROST), whose dividend yield is only 0.8%.

So the almost certain scenario is that Starbucks’ DGR will gradually come down.

We can see in the first table that its dividend growth rate in 2015 was 6 percentage points lower than its 5-year average DGR.

It is foolish, in other words, to project that Starbucks (or any company) will maintain a dividend growth rate of anywhere near 20% per year for a really long term.

That likely slowdown in annual growth, of course, would lengthen the timeframes that we discussed above. In fact, it is possible to construct a scenario in which Starbucks cumulative total dividends paid never passes AT&T’s, because Starbucks’ growth may slow enough that it never overcomes the early lead that AT&T gained from its higher initial yield.

So remember, when comparing dividend growth stocks, look at both the initial yield and the historical dividend growth rate, and then also consider how long the faster-growing company can maintain that rate of growth. You won’t be able to pinpoint that exactly, but you can make an educated guess.

My own approach to this question of growth vs. yield is that I like to have a mixture of both kinds of stocks in my portfolio. It is a form of diversification. (See DGI Lesson 16: Diversification.)

Lessons

The takeaways from this article are:

• Never assume that a faster-growth dividend stock is automatically better.
• For that matter, never assume that a high-yield stock is better either.
• Instead, examine the interplay between yield and growth rate for both stocks.
• A stock with a higher yield gets a significant head start in delivering both dividends per year and cumulative dividends over many years.
• “Better” is subjective. It may depend on your age, current income needs, and other factors.
• Projecting high DGRs infinitely into the future is foolhardy. Every company’s dividend growth rate eventually reverts to a level similar to its earnings growth rate.
• Consider owning both high-yielders and fast-growers to help diversify your portfolio.

For a complete list of Dividend Growth Investing Lessons, click here.

— Dave Van Knapp

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