Friday, September 4, 2015

The value of dividend growth in retirement planning

Some regular readers might remember that in my retirement planning, I estimate that I will be able to allocate my capital at yields between 3- 4% and dividend growth between 6 – 7%. If I am lucky, the above numbers will result in roughly doubling of dividend income every seven years or so. This means that if I had a dividend portfolio that generated $1000 in annual dividend income today, I could reasonably expect that through meticulous and opportunistic reinvestment of dividends and through the power of dividend growth, I will be able to double this to $2000/year in seven years.

In order to generate $1000 in annual dividends, one needs anywhere from $40,000 invested at 2.50% to $25,000 invested at an yield of 4%. Of course, in a somewhat efficient marketplace for common stocks, investors who require higher current yields today tend to forego some of the expected dividend growth. On the other hand, some are fine sacrificing some current yield today, in order to capture estimated dividend growth in the future. As discussed previously, there is a trade-off between dividend yield and dividend growth. The balance is determined based on investors reasonable expectations against the realities of opportunities available at the time.

I buy dividend growth stocks, because I want to earn dividend income that grows over time. When this annual rate of dividend growth is above the annual rate of inflation, this means that I have maintained purchasing power of my income. However, I have heard arguments that one could maintain the purchasing power of their dividend income, provided they reinvested the dividend back into securities that pay high dividend yields. Therefore, if you own a stock yielding 4% that never increases dividends, but you reinvest dividends at same or other security yielding 4% at the moment, your income will increase by 4% for the year. If inflation is below 4%, you would have essentially slightly increased purchasing power.


I compared three scenarios of dividend reinvestment, over a period of 20 years. The basic inputs in each scenario is that an initial amount of $25,000 is invested in dividend paying stocks, yielding 4% in year 0. Starting prices are $1/share, which are adjusted for growth of dividends annually. Dividends are reinvested into more shares in the year they are received, at the price available at year end. For the purposes of illustration, I am assuming that company A never raises dividends, and stock price is always at $1, while the annual dividend is always at 4 cents/share. For company B, the assumptions are 6% in annual growth in stock prices and dividends. I wanted to compare these three scenarios, in order to illustrate the point that dividend growth is pretty valuable.

For the investor in company A, they earned $1000 in year one. After 20 years of reinvesting dividends, the amount of annual dividend income is almost $2107/year.

For the investor in company B their annual dividend income increased from $1060 in year one to $6129/year by year 20.

It is obvious that dividend growth investor in company B managed to earn more over time. In fact, the only way that the investor in company A could have kept up with the dividend income for investor B was by actually contributing additional capital. In the table below, I am going to show how valuable dividend growth could be for the individual investor.

Therefore in year one, the investor in company A should have put $1500 towards additional share purchases, just so they could earn $1060 in annual dividend income. The investor in company A should have put money in additional purchases, simply to keep up with the growth in annual dividend income for investor B in company B. He or she (A) is putting more to work than in year 1, because investor B not only earns the same 4% yield, but their dividend income per share goes up by 6%/year.

It seems that over the next 20 years, the investor in company A needs to put $76,902 in additional capital, merely to keep up with dividend income generated by company B. It is important to realize that dividend growth is an important tool in your arsenal of achieving financial freedom. Dividend growth is a result of the internal economic engine that allows companies you invest in to earn more and pay you higher dividends over time. Without any further effort on your part, dividend growth companies do most of the heavy lifting in your pursuit of financial independence. You are leveraging the hard work and capital allocation of the employees of these compounding machines, and generating the earnings fuel to generate dividend growth. By investing in dividend growth stocks, you are essentially making your money work for you, rather than the other way around. The added bonus of course is that companies that earn more and pay more in dividends over time, tend to also become more valuable as well.

Therefore, whenever I consider between companies with high yields today with low or minimal growth today and higher dividend growth companies, I always choose the latter. At some point, even the juiciest yield today is not worth it to a long-term investor such as myself, in comparison to a company with steady dividend growth.

Full Disclosure: None

Relevant Articles:

The Value of Dividend Growth
Dividend Growth Stocks Increase Intrinsic Value Over Time
How to retire in 10 years with dividend stocks
Reinvest Dividends Selectively
Dividend Stocks Provide Protection in Any Market

20 comments:

  1. What would the analysis look like if you compared a no growth 6% yielding stock with a 3% yielding stock with 6% annual dividend growth?

    ReplyDelete
    Replies
    1. It would look bad for the 6% yielding stock. The retiree starts off with high income, and then proceeds to consistently lose purchasing power over their 30 year retirement.

      Delete
  2. While saving for retirement, Dividend Growth is a great strategy. But as a person gets closer to retirement, reinvesting the dividends and any additional funds in higher Dividend yielding stocks will give the retiree more income in retirement without having to liquidate any positions.

    ReplyDelete
  3. Like in all investing, my belief is that diversification is the key. Therefore, I am invested in different types of dividend growth stocks, both high yield low growth, and vice versa.

    I like high yielders because they give me current income that I can invest in high growth stocks. I like low yielders with high growth because they will give me high income years from now

    ReplyDelete
    Replies
    1. Diversification for the sake of diversification is usually not a good idea.

      Investing in a high yielding company like Con Edison has an opportunity cost, which will be felt by the investor after 10 years of income going nowhere and losing purchasing power in the process.

      Delete
  4. I tend to agree with Richard above. You mention yourself that dividend growth often comes at the sacrifice of current high yield. To me, it's obvious that the growth scenario wins if the starting yield is the same. The more illustrative point is to find the breakeven point between a stock like T (5% current yield, low growth) and TROW (2.8% current yield, high growth) - assuming no or identical contributions and similar price appreciation.

    ReplyDelete
    Replies
    1. Richard asked a question. He didn't make a statement

      An investor in TROW has always better off than an investor in T over the past 10 - 15 - 20 years

      Delete
  5. Is the growth rate nominal or real? A separate column showing the present value of the future dividend might be useful with say 3% inflation. The numbers won't be quite a large.

    ReplyDelete
    Replies
    1. This is irrelevant for the purposes of this article

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    2. Really? The topic is value for retirement. The real purchasing power most certainly is relevant. It's your blog though.

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    3. The purpose of this post was to show specifically how important dividend growth is over a static dividend.

      Adding a 3% inflation, or taxation or anything else is a distraction that will further complicate calculations in this article, but will not add any materially important information that would cause me to change the conclusion.

      So it is irrelevant for the purposes of this article.

      Delete
  6. Exactly. While most high yield dividend's stocks don't grow annually, their yield are much higher than those who grow over time. You need to look at real data in your comparison.

    ReplyDelete
    Replies
    1. Chasing yield coupled with a largely static dividend is usually not a good strategy. It leads to higher likelihood of a dividend cut, loss of purchasing power to inflation and lower ability to maintain purchasing power of the nest egg

      Delete
  7. DGI,
    Thanks for writing this article. I have been wondering about this topic for a while. I am 32 and heavily invested in dividend growth stocks. I reinvest my dividends in current opportunities that I see attractive. My concern is when I do want to retire it will be imperative that I maximize my dividend yield against a manageable risk. I often visit www.theyieldhunter.com, where preferred shares often give 6%-7% yields with little fluctuation in stock prices. Also when bond yields rise I see gaining the highest safest yield, while reinvesting 6% of the gains would be a better strategy.

    For example a $1,000,000 portfolio yielding 6% would receive $60,000 in dividend income. If one were to take 6% of the $60,000 income and reinvest it into the $1,000,000 balance to get 1,003,600 with the same 6% yield and receive $60,216, thus beating a 3% inflation. Just wondering your thoughts. I see divided growth investing as the best way to accumulate the highest portfolio amount until switching to a retirement strategy.

    ReplyDelete
    Replies
    1. The problem is that you do not know what inflation will be like in the future. So when the most you can get is 6%, you are setting yourself up for failure if something unexpected comes up your way - higher than expected inflation, a dividend cut, etc. You need a margin of safety.

      With a company yielding 3 - 3.50% today, I have a payout of say 40 - 50% - so that's one level of safety. I also get some earnings and dividend growth -that is another level of safety. I don't shoot for the stars, but go for a slow and steady approach, that will be successful under most scenarios I can foresee.

      Delete
  8. It appears that your article could be summed up as - If you buy a fixed income (you call it a stock) investment yielding 4% or a stock that yields 4%, increases its dividend consistently every year, never goes down and hold for 20 years you will have more money if you buy the stock rather than the fixed income asset. I'm not saying that your scenario isn't possible. It just seems like you started out with the answer you wanted and created the example that supports the answer. You assign all the negatives to the fixed investment and all the positives to the stock that increases it's dividend and declare the dividend stock the winner.

    ReplyDelete
    Replies
    1. Well, after observing investor behavior for the past 8 years, I can tell you that a large portion of investors fixate on the dividend yield, and few ask themselves whether it is sustainable or whether it will grow.

      If you are earning a 4% yield from a dividend that never grows, you are worse off than someone else earning a 4% yield from a dividend that grows. If you want it illustrated, just look at ED over the past 10 -15 years. I see articles talking about "steddie edde", and the yield chasers just blindly go there, despite the fact that future expected returns can not be much more than 5%/year. This is not enough to fight inflation, and live off and is not adequate compensation for the risk that Steddie Eddie cuts dividends.


      Delete
  9. I love your blog, but this particular analysis is unfortunately wrong. Frankly, you're comparing apples to oranges.

    Assuming you never intend to sell the security (also: no buybacks and dividend taxes) the total rate of return equals dividend yield plus earnings growth rate (this comes from the Gordon's Model).

    Company A has a lower return on equity (4% + 0% = 4%) than Company B (4% + 6% = 10%), that's why you got this results. In real world the first company is similar to a REIT, it's just a pass-through security, whereas B would be a normal stock.

    Basically, if the companies had the same earnings, the dividends would not be taxed and the reinvestment would be costless, than you'd get the same results.

    ReplyDelete
    Replies
    1. I illustrated a very simple and very basic concept in this article. I am dissapointed that almost noone understood the concept discussed and noone understood the purpose behind the article.

      As for your comment - if this article were so out of touch with "the real world". then how come people are buying ED, UBA, or MSEX, despite their terrible 10 year record for dividend growth?

      For many, dividend investing is all about chasing yield. This is dangerous, and will lead to disappointing results down the road.

      Delete

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