Growth vs. Dividends
There is a tradeoff between high dividends and long-term earnings growth. Obviously the more cash a company pays out to its shareholders, the less it has to fund growth without either issuing more debt or more equity. That can be a dangerous game to play.
However, it’s not uncommon for solid businesses to distribute more and more of their earnings to shareholders through higher dividends as they mature. Bigger companies have less growth opportunities and compete in crowded markets, so they plow back less of their earnings into the company and more into your wallet.
But if a company is going to increase its dividend over time, it needs to grow earnings and cash flow to do so. This is why it’s important to know a company’s sustainable growth rate.
The sustainable growth rate is the maximum growth rate that a company can sustain without having to issue more debt or more equity. It is calculated as:
(1 – Payout Ratio) x Return on Equity
For example, say a company pays out 30% of its earnings in dividends and its ROE is 15%. Its sustainable growth rate would be 10.5% (.70 x .15). Clearly the lower the payout ratio and higher the ROE, the higher the sustainable growth rate. That means higher future cash flow growth and, likely, higher future dividend growth.
The Tortoise vs. the Hare
Imagine that you have the choice to invest between two different stocks for the next decade – Tortoise Corp or Hare Corp.
Fictional Tortoise Corp currently has a relatively low payout ratio, a solid balance sheet and a high sustainable growth rate. It trades for $50 per share and currently pays a dividend of $1.25 for a yield of 2.5%. It earned $3.75 per share this year, so its payout ratio is currently 33%. Its return on equity is 20%. Let’s assume that over the next 10 years, Tortoise Corp increases its payout ratio linearly to 67%.
Meanwhile, Hare Corp also trades for $50 today and earned $3.75 per share this year. But it pays out 90% of its earnings as a dividend for a yield of 6.8%. Its ROE is 10%. Since Hare Corp already pays out so much of its earnings in dividends, it doesn’t raise its payout ratio. It also doesn’t have much to invest in future growth, so its earnings grow at a much slower rate.
Investors focused solely on current yield would jump into Hare Corp for its higher dividend. But the stronger total returns will very likely come from Tortoise Corp.
In fact, both companies in this scenario will pay out about the same amount in total dividends over the next decade (ignoring the time value of money). But by year 10, Tortoise Corp will have more than double the earnings of Hare Corp and a higher book value too. Slow and steady wins the race.
Clearly, a company’s dividend growth potential should be very important for long-term investors.
The Bottom Line
Beware the siren call of high yield stocks. A big yield may look attractive at first glance, but investors are usually much better off focusing on a company’s dividend growth potential.
That is one reason we developed a portfolio that I am managing called Zacks Income Plus.
The other reason is that very few years are like 2013 with a wonderfully calm, steady upward swing.
Already we’re seeing a lot more market volatility this year, and many investors prefer a smoother path to outperforming the S&P 500. So our Income Plus Investor is designed to combine high-paying dividends (more than twice the average for S&P stocks) with dynamic potential growth. Today, 9 of our stocks are gaining well into the double-digits and the ends of those booms are not yet in sight.
Would you like to find out more about this portfolio? Click below and you’ll also see two new moves I am exploring right now. One is a currently undervalued real estate investment trust that has increased its dividend every year since 2010 at a +13% compound annual growth rate. Another is a major beverage stock with great cash flow that has also rewarded its thirsty shareholders with consistently bigger dividend payments.
Todd Bunton, CFA is Zacks Growth & Income Strategist. He manages our Income Plus Investor, which detects companies that not only pay high dividends but are also likely to see exceptional price appreciation.