Monday, November 17, 2014

The Secret Ingredient of Dividend Growth Stocks

When people learn that I am an income investor it is not uncommon for them to ask why I invest in stocks instead of  other "safer" alternatives such as bonds, high yield money market accounts [MMA] or certificates of deposits [CD]. I generally start with my short answer of, "Dividend stocks have a secret ingredient that makes them a much more desirable investment."

Needless to say this usually piques their interest and normally the response is something like, "Secret ingredient? What secret ingredient?" Then I explain.

Dividend Stocks Hidden Power

Let's assume you can find a CD that earns a similar rate as the dividend stock (a stretch now days, but stay with me) and it is federally insured, thus protecting the purchaser from loss. So it must be better, right?

What separates good dividend stocks from bonds, MMAs and CDs is a hidden power not readily recognizable to the uninitiated - dividend growth. While a CD will pay a market interest rate for its term, its only growth is movement in the market rate at renewal, which can go either up or down. Contrast that with a good dividend stock with decades of consecutive annual dividend increases.

Dividend Stocks Yield On Cost

One way to compare the earning power of two investments or an investment and a CD is to look at their Yield On Cost [YOC] over time. YOC is a simple concept where you divide annual earnings over the investment's original cost. Consider this simple example of a stock with a 2.75% yield and a dividend growth rate of 7%, compared a 5-year CD paying 3.00%, where earnings in both are withdrawn when paid:

Div. Stock CD
Investment $ 10,000 10,000
Initial Yield 2.75% 3.00%
Div. Growth 7.0% 0.0%
Earnings Yr. 1 275 300
YOC Yr. 1 2.8% 3.0%
Earnings Yr. 2 294 300
YOC Yr. 2 2.9% 3.0%
Earnings Yr. 3 315 300
YOC Yr. 3 3.1% 3.0%
Earnings Yr. 4 337 300
YOC Yr. 4 3.4% 3.0%
Earnings Yr. 5 360 300
YOC Yr. 5 3.6% 3.0%
Earnings Total 1,581 1,500
YOC Final 3.6% 3.0%

Though the dividend stock started with a lower yield of 2.75%, its final YOC after 5 years was 3.6% compared to the constant 3.0% of the CD. The key here is to find dividend stocks that are growing their dividends and will continue to do so. Since these numbers are contrived, the obvious question is how does this translate to the real world?

Dividend Stocks The Last 10 Years

Below are some bellwether dividend growth stocks and their performance over the last 10 years, assuming the stock was bought at the its 2004 high price:
General Dynamic (GD)
- 2004 Dividend per Share: $0.70
- 2004 High Share Price: $54.99
- 2004 Yield on High Price: 1.3%
- 2014 Dividend per Share: $2.42
- 2014 Yield On Cost: 4.4%
- Current Yield: 1.8%

Johnson & Johnson (JNJ)
- 2004 Dividend per Share: $1.095
- 2004 High Share Price: $64.25
- 2004 Yield on High Price: 1.7%
- 2014 Dividend per Share: $2.76
- 2014 Yield On Cost: 4.2%
- Current Yield: 2.6%

Coca-Cola Company (KO)
- 2004 Dividend per Share: $0.50
- 2004 High Share Price: $26.75
- 2004 Yield on High Price: 1.9%
- 2014 Dividend per Share: $1.22
- 2014 Yield On Cost: 4.6%
- Current Yield: 2.9%

McDonald's Corp. (MCD) - See Full Analysis
- 2004 Dividend per Share: $0.55
- 2004 High Share Price: $32.93
- 2004 Yield on High Price: 1.7%
- 2014 Dividend per Share: $3.28
- 2014 Yield On Cost: 10.0%
- Current Yield: 3.6%

Proctor & Gamble (PG)
- 2004 Dividend per Share: $1.03
- 2004 High Share Price: $59.70
- 2004 Yield on High Price: 1.7%
- 2013 Dividend per Share: $2.58
- 2013 Yield On Cost: 4.3%
- Current Yield: 2.9%

The above data demonstrates another important concept - growth is more important than starting point. By using the high stock price for 2004, you would have purchased the stock at its absolute lowest yield for the year. After 10 years of growth, the YOC is significantly higher than the stocks' current yield and yield on the date it was purchased. Also, note that the current yield is similar to original yield for most of the stocks, which means the share price had to grow at a similar rate as the dividend rate. Stock appreciation and income growth - it just doesn't get any better than that!

Full Disclosure: Long GD, JNJ, KO, MCD, PG, in my Dividend Growth Portfolio. See a list of all my dividend growth holdings here.

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