One of the first things most investors look for in a dividend stock is the current yield. You will commonly hear things like “… stock XYZ is yielding over 6% … or “… stock ABC has a higher yield than its peers …”. While there is no doubt the dividend yield can be a useful factor in selecting the top dividend paying stocks, it is certainly not the most important.
There is actually a lesser known (but just as important) financial ratio that investors can use to screen dividend stocks. This financial calculation is called the dividend growth rate and can provide beneficial data for the investor. Let’s take a look at both financial ratios and why calculating the growth rate is important.
What is Dividend Yield?
The yield of a stock is a financial ratio which calculates the percentage paid out to shareholders in dividends compared to the current share price. This percentage represents an estimate of the return on investment an investor could expect in dividends. The calculation assumes that the company will not make any dividend cuts and will either maintain the current payout or increase their distribution to shareholders.
The dividend yield of a company can be calculated as follows -
Yield = Annual Dividends Per Share / Price Per Share
Let’s look at an example of calculating the current yield of a stock. If an investor were interested in purchasing shares of company ABC, they may want to understand how the yield is calculated. Let’s assume the company is currently trading at $30 per share and paid out $1.50 in dividends per share over the past twelve months.
Using the equation above, the investor could quickly calculate (and understand) the dividend yield of the company. By dividing $1.50 by $30, the investor can calculate the company has a current yield of 5.0%. If a month goes by and the share price increases by $2 per share (with no dividend change), the investor can then calculate the current yield has decreased to 4.7%.
It is important to note that the current yield is constantly changing for a stock, as it relies on the share price (which is always moving up and down). An investor who purchased the stock at a higher price six months ago will have a much lower return (yield) on their investment (assuming the dividend remained constant) than someone who recently invested in the company. On the other hand, investors who bought at a lower share price (than the current price) would have a higher yield on their investment.
What is the Dividend Growth Rate?
The dividend growth rate of a stock is the annualized percentage increase in dividends for a certain period of time. For example, an investor may want to know what the 5 year dividend growth rate of a company is for his/her analysis. The time period for the calculation can be any desired interval (i.e. 5 years, 10 years, etc.).
On average, a company that has a solid history of strong dividend growth is more likely to continue raising dividends compared to a company with slow or negative dividend growth. For example, a company that has consistently raised its dividend by 10% annually for the past 10 years is likely to continue that trend. Assuming the trend continues, investors would receive a 10% raise in income just by owning shares in the stock.
When was the last time your job could guarantee you a 10% raise every year?
Why Dividend Growth is More Important than Yield
The main drawback of relying solely on the yield of a stock is when the company decides to cut their dividend. Most calculations use the annual dividends per share paid out over the past 12 months divided by the current share price. Since there is no guarantee the company will continue to pay the same amount of dividends, the results can become skewed. So in reality, the yield is using the past dividend performance and measuring it against the current value (or share price) of the stock, which can be misleading to an investor.
Factoring in the dividend growth rate, on the other hand, can actually highlight stocks that may have fallen off your radar. Many companies that have a double digit growth rate generally have below average current yields making them unattractive to the common investor. Let’s take a look at a company that has a current yield of 2.5% that has a growth rate of 10%.
Consider the return on investment you would receive in 10 years as the company increases its dividends by 10% annually.
- Year 1 – 2.50%
- Year 2 – 2.75%
- Year 3 – 3.03%
- Year 4 – 3.33%
- Year 5 – 3.66%
- Year 6 – 4.03%
- Year 7 – 4.43%
- Year 8 – 4.87%
- Year 9 – 5.36%
- Year 10 – 5.89%
- Year 11 – 6.48%
As you can tell by the numbers above, in year 11 (10 years after the first increase), your original investment would be returning almost 6.5% in dividends. Compare those numbers with a stock that has a really high current yield and you won’t see the same returns.
The bottom line is that factoring in the dividend growth rate can identify top notch dividend payers that give investors an annual raise that can’t be beat.
Should investors only use the dividend growth rate to identify top dividend stocks? No. Neither should you use the current yield to make all of your investment decisions. The reality is that both ratios are important factors in picking the top dividend stocks for your portfolio. However, the dividend growth rate does provide useful historical information that provides more answers as to the direction the stock is heading.
Do you use the dividend growth rate to help screen stocks?