There are two metrics which are king and queen for dividend-seeking investors: dividend yield and dividend growth. However, often times when comparing several investment opportunities, it becomes very important to understand exactly the impact of each of these metrics in your investments. While they are obviously both important, what would prefer, modest yield & high growth or high yield & modest growth?
The right answer is: It depends. It's easy to get carried away by double digit dividend growth, but remember that the growth is applied to the current yield, which normally is a very small number thus resulting in a small increase. So, it is important to run to the the actual calculations and understand the impact of the growth on current yields.
As an example, I am going to use two companies loved by many dividend investors - AT&T (T) and Wal-Mart (WMT). This is just for example sake, I am not advocating investing on one over the other, nor am I taking into account the companies' underlying quality into account. I am purely looking at them from the dividend metrics perspective.
Dividend Yield: 2.57%
Dividend Growth: 15%
Dividend Yield: 5.5%
Dividend Growth: 2%
At first sight, this would look like a hard decision. WMT has roughly half the dividend than T but its dividend grows at a much higher rate (7 times higher). As high as T's yield is, and as high as WMT growth is, the choice here is not obvious. Let's run some numbers and see how both yields would evolve with time:
The conclusion is that, even with such a high growth, WMT's yield would only reach a comparable dividend yield to T on your 6th year holding the investment. Also, remember that it is much easier for companies to slow down the dividend growth on tough years (as WMT did this year), than it is to actually cut their dividend, so all things being equal, there is a higher probability of the big dividend grower, to grow at a slower pace at some point in the span of 7 years.
Additionally, if you are re-investing the dividends, each year you will be entitled to a larger slice of the profits pie. So, remember that during the years where you have a higher yield, you were also re-investing a larger sum.
Of course in most cases, companies with high yields and low dividend growth are probably facing tough headwinds, while companies with low dividends and high dividend growth have confident expectations on their medium-term growth.
Ultimately, it is not trivial to choose, but the point I wanted to make with this post, was highlighting that a strong dividend growth is a future promise that might be broken, even for high-quality companies (like WMT this year). So, for me, the choice between both metrics is not obvious and I always run these calculations to be able to estimate when the growing dividend will catch up with the high yield.
What about you, how do you decide between growth and yield?