Dividend Growth vs. Dividend Yield: Honing Your Investment Strategy
Posted on June 07, 2013 by admin
Guest Post: Angie Picardo
Dividend Growth vs. Dividend Yield: Is a higher yield at low growth better than a high growth stock with low yields? Well, before we answer that question, let’s create some working definitions and explanations.
When a company is turning a profit, it has two choices: it can put the profits back into the business to open more branches or research new products, or it can pay out the profit to shareholders. This payout is called a dividend.
The dividend yield is a ratio that shows how much a company pays out in dividends annually relative to its share price. This figure is often used to calculate the return on investment of a stock. To figure out your dividend yield, divide the annual dividends per share by the price per share. As an investor, you can use the dividend yield figure to measure how much money you’re getting for each dollar invested into the company’s stock.
Let’s look at an example. Imagine you’ve invested in two companies: French Bakery Company and Ice Cream-o-Rama. French Bakery Co. is currently trading at $20 per share and its annual dividend is $1 per share. On the other hand, Ice Cream-o-Rama is trading at $40, but also paying $1 per share. So, which investment is paying off more? You get a dollar for each share for each company, so the actual dollar amount is equal, but the dividend yield is different. Assuming you only have one share of each (for easy math), divide the annual dividend (one dollar), by the share price ($20 for French Bakery and $40 for Ice Cream-o-Rama). That leaves us with 0.05 and 0.025, respectively. To finish the calculation, multiply each number by 100 (that gives a percentage amount). That means that French Bakery is yielding a 5% return on investment, while Ice Cream-o-Rama is only yielding half of that: 2.5%.
Dividend growth is a profit produced from the growth of a stock price. It is a measure of how much a dividend will grow over time and what the anticipated payout to you, the investor, will be. There are many factors to take into account when choosing a stock for dividend growth and you should know what your end goal is for the investment. Are you hoping to generate a large steady income over time, or a potentially fluctuating amount over a shorter period of time? In order to maximize dividend growth, you need to consider how the growth rate and the initial yield will work together over time.
The benefits from dividend growth are largest when you invest in a company before it becomes large and successful. Say you invest $1,000 in Soda Brand Sodas at $100 per share. At first, dividend growth is low because the company is new and it is using most of its profits to invest in the company. It has a payout ratio of 10%, or $1 per share. Next year, the stock price goes up to $200 per share, although the payout ratio remains the same at 10%. Since the stock price has gone up, your payout increases to $2 per share, or $20. This means that for your initial investment, you’ve now made $3 per share in dividends over two years. That isn’t much, but if we assume that the company was successful over the next 30 years, even if the stock price didn’t increase much more, your investment would still show a large return. Dividend growth is a powerful investment tool because it benefits investors in the long run.
How to Choose
When comparing dividend growths and dividend yields, dividend growth is often a source of income for slow, predictable investments, while dividend yields often produce more profits from risky, volatile shares. And to a certain extent, this is true. Stocks with a lower growth potential are more likely to offer higher dividend yields to entice investors.
Look at a lot of factors when you choose your investments and figure out what’s best for your portfolio. If you want a high return on investment soon, it may be worthwhile to invest in some of those riskier high-yield stocks. However, be advised that very high dividend yields (10% and up) are often scams or traps for unwary investors. You should also know that a company can stop offering dividends anytime it wants to, so be sure to keep up with what is happening with your investments.
Finally, remember to diversify. There is no single, magic solution to having a perfect portfolio. Research stocks that have dividend yields and dividend growth at a variety of values and look up charts for how your profits compare (the 10 by 10 Table for Dividend Investors is a good one). Invest in some stocks that have a high yield and some that have a high level of growth as a combination of the two is going to yield the most income altogether. There are also many other ways to make money from your investments! Don’t ignore other types of stocks just because they don’t offer a dividend.
Do your research, diversify, and enjoy your newfound passive income.
Angie Picardo is a staff writer for NerdWallet, a website dedicated to helping consumers alleviate debt and better save by setting financial goals.
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