High Yield or Growth?

Last week, I discussed how focusing on high-yield alone when picking stocks is an investment mistake. This week, I will use a simple example to show how earnings and dividend growth can lead to superior returns over a stock that offers high yield but little else.

Consider two hypothetical stocks, A and B.

Let’s assume both A and B have an earnings per share (EPS) of $2 at the starting point (Year 0 in the accompanying tables), and both stocks are valued at 10x trailing-12-months earnings. Thus, both stocks are valued at $20.

However, the two stocks differ in their dividends and they also have different EPS and dividend growth rates.

High Yield vs. Positive EPS and Dividend Growth

Stock A pays a $1.50 annual dividend per share, and B pays only $0.50, three times less than A.

A has no earnings or dividend growth, whereas B’s EPS grows at 8% per year and its dividend at 5% per year.

Recall that a stock price will adjust for the dividend that the company pays. Therefore, at the starting point, Stock A trades for $18.50, and Stock B trades for $19.50 (marked in green in the tables below).

The tables show how the stock prices will change over five years. The table cells marked in yellow shows what the prices at the end of Year 5 will be.

As you can see, for Stock A, because it has no earnings or dividend growth, at the end of Year 5 the market price is the same as the purchase price, so the price return is zero. There is no capital appreciation.

However, you do receive $1.50 in dividend per share each year, so to calculate total return you must add back the total dividend ($7.50) received over the five years of holding period to the ending price.

Adding $7.50 to $18.50 gives you $26. Dividend $26 by $18.50 and then subtract 1 and you get the total return of 40.5%.

For Stock B, notice in the table that the EPS and dividend are increasing by the stated rates each year. Using the same method we used for Stock A, we find that the total dividend received is $2.90, and adding that to the ending price of $28.75, dividing by the purchase price of $19.50 and then subtracting 1 gives us a total return of 62.3%.

Growth Trumped High Yield

The stock with the much lower yield but positive earnings and dividend growth significantly outperformed the high-yield but no-growth stock over time. If you only picked the stock based on yield and didn’t pay attention to other factors, you would have picked the stock with the lower return.

Additionally, note that Stock B’s dividend yield actually went down, to 2.2% ($0.64/$28.75)! In this case, the yield fell because the stock price went up at a faster rate than the dividend. Thus, if you own a stock and its yield falls, it’s not necessarily a bad thing.

Of course, in the real world, things won’t be quite this simple. For example, growth won’t be so linear and the pricing of a stock won’t depend only on EPS multiple and dividend payout. You will also have to take into consideration tax implications of dividend vs. capital appreciation, and also consider the returns you could earn by reinvesting dividend received. The hypothetical situation is purposely kept simple to illustrate a point.

To be clear, the point of the exercise isn’t to say that high-yield stocks are not good investments. In the example, even though the price of Stock A stayed the same for five years, the overall return was still about 40%. Rather, the point is that investors shouldn’t automatically choose the stock with the highest yield and ignore other factors. The highest-yielding stock could turn out to be the most sensible purchase, but you need to do your due diligence before you make that determination.

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