Sunday, January 20, 2008

A comparison of investing in high-yield, low dividend growth stock versus investing in a low-yield, high dividend growth stock without capital gains

I was asked before about the reasoning behind my statement that I would buy a stock whose dividend is increasing even by one percentage point per year, if it has a high yield, rather than invest in stocks which increase their dividend payment by at least 10% per year. To answer this question, lets me walk you through my calculations:

Let’s say that you have 2 stocks- A and B in each of which we invest $100,000. We assume that both stocks will always trade at $10 for simplicity sake. Stock A is yielding 5% per year (50 cents per share), while Stock B is yielding 2% (20 cents per share). The dividend growth in Stock A is a meager 1%, while Stock B’s dividend is growing at 5% annually. We will look at two outputs – total return and changes in annual income. It would take stock B 24 years to reach the same annual income level as stock A. In addition, it would take stock B around 40 years to achieve the same total dollar return as stock A. If however we had a growth stock C, which was yielding .5 % at the start of the experiment, and whose dividend was growing at 10% annually, it would take the annual income around 27 years to reach Stock A’s dividend income. It would also take around 42 years for the total dollar return of Stock C to reach the total dollar return of Stock A. I have also included a $100,000 investment in bonds, which yield 6% every year.

The return from the invested capital though, would have been increasing substantially over time assuming that we didn’t reinvest our dividends back into our stocks. After 10 years the yield on cost for Stock A is 5.5%, Stock B is 3.3% and Stock C is 1.3%. After 10 more years stocks A, B and C are yielding 6.1%, 5.3% and 3.4%. An investor, who simply purchased bonds, would have been making the same 6% over and over. I am attaching my spreadsheet below. This file is for informational purposes only; I just tried to make my point that you have to not only buy a stock which has a high dividend growth rate, but also a one which has a pretty decent yield. A major limitation of this analysis was that I assumed that stocks would not realize any capital gains over the period; that’s why the long-term results of Stocks A, B and C are almost identical to long-term results for Bonds. However it shows you that if you reinvest dividends, stocks achieve a higher compounding power than bonds.
You can see the file here or here.

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