Dividend Growth Investing is by nature a long-term, value based, investment strategy. Once a target list of safe, cheap companies has been determined one must then, determine which to purchase. When choosing between two potential investments, one must, at some point, confront the issue of current yield versus dividend growth. The simple rule of thumb that says a stocks long-term return is equivalent to the yield on cost plus the dividend growth rate would seem to tell you that, all else being equal, all you need do is add these measures together to determine the better investment. Is this in fact the case?
The answer depends largely on the anticipated holding period for the stock. When evaluating two similar potential investments, I typically look at five and ten year holding periods and discount the income streams by 3% per year which is my long-term inflation assumption.
Let us look at a real world example:
Coke (KO) versus Pepsi (PEP)
On May 7, 2009, KO was trading in a range around $43.00 per share and has a dividend of $1.64 (Yield of 3.81%). PEP was trading in a range around $50.00 with a recently increased dividend of $1.80 (Yield of 3.60%) KO has a long-term record of increasing its dividend at a CAGR (compound annual growth rate) of 9.7%, while PEP over the same 10-year period has increased its dividend at a 12.4% CAGR
While the difference in initial yield between KOs’ 3.81% and PEPs’ 3.60% may seem insignificant in relation to the difference between their long-term dividend growth rates, the higher initial yield provided by KO outweighs the growth advantage that PEP offers for five years. After five years, the advantage goes to PEP.
| | Initial Investment | $ 100,000 | ||||||
| | LT Inflation Assumption | 3% | ||||||
| | Company | KO | Company | PEP | Nominal Cumulative Income Differential | Inflation Adjusted Cumulative Income Differential | ||
| | Initial Yield | 3.81% | Initial Yield | 3.60% | ||||
| | LT Growth Rate | 9.70% | LT Growth Rate | 12.40% | ||||
| | Yield on Cost | Income $ | Yield on Cost | Income $ | ||||
| | Annual | Cumulative | Annual | Cumulative | ||||
| Year 1 | 3.81% | $3,810 | $3,810 | 3.60% | $3,600 | $3,600 | ($210) | ($204) |
| Year 2 | 4.18% | $4,180 | $7,990 | 4.05% | $4,046 | $7,646 | ($343) | ($329) |
| Year 3 | 4.58% | $4,585 | $12,575 | 4.55% | $4,548 | $12,195 | ($380) | ($363) |
| Year 4 | 5.03% | $5,030 | $17,604 | 5.11% | $5,112 | $17,307 | ($298) | ($290) |
| Year 5 | 5.52% | $5,518 | $23,122 | 5.75% | $5,746 | $23,053 | ($69) | ($93) |
| Year 6 | 6.05% | $6,053 | $29,175 | 6.46% | $6,459 | $29,511 | $337 | $247 |
| Year 7 | 6.64% | $6,640 | $35,815 | 7.26% | $7,259 | $36,771 | $956 | $751 |
| Year 8 | 7.28% | $7,284 | $43,099 | 8.16% | $8,160 | $44,930 | $1,831 | $1,442 |
| Year 9 | 7.99% | $7,991 | $51,089 | 9.17% | $9,171 | $54,102 | $3,012 | $2,347 |
| Year 10 | 8.77% | $8,766 | $59,855 | 10.31% | $10,309 | $64,410 | $4,555 | $3,495 |
| Year 11 | 9.62% | $9,616 | $69,471 | 11.59% | $11,587 | $75,997 | $6,526 | $4,919 |
| Year 12 | 10.55% | $10,549 | $80,020 | 13.02% | $13,024 | $89,021 | $9,001 | $6,654 |
| Year 13 | 11.57% | $11,572 | $91,591 | 14.64% | $14,639 | $103,659 | $12,068 | $8,743 |
| Year 14 | 12.69% | $12,694 | $104,286 | 16.45% | $16,454 | $120,113 | $15,827 | $11,228 |
| Year 15 | 13.93% | $13,926 | $118,212 | 18.49% | $18,494 | $138,607 | $20,395 | $14,160 |
| Year 16 | 15.28% | $15,277 | $133,488 | 20.79% | $20,787 | $159,394 | $25,906 | $17,594 |
| Year 17 | 16.76% | $16,758 | $150,246 | 23.36% | $23,365 | $182,759 | $32,513 | $21,591 |
| Year 18 | 18.38% | $18,384 | $168,630 | 26.26% | $26,262 | $209,021 | $40,391 | $26,219 |
| Year 19 | 20.17% | $20,167 | $188,797 | 29.52% | $29,519 | $238,540 | $49,742 | $31,552 |
| Year 20 | 22.12% | $22,123 | $210,921 | 33.18% | $33,179 | $271,719 | $60,798 | $37,673 |
Admittedly, the differences in the above table are small and other considerations would likely outweigh them, but my purpose here is not to say that KO is a better income stock than PEP. Rather it is to provide one specific tool to use when evaluating a choice between two competing choices for an investors dollar.
Disclosure: Long KO
