Categories
Investing

Large Static Dividends Vs Small Growing Dividends

I thought it might be useful to graph the difference between a hypothetical company paying a large dividend that doesn’t grow compared with a hypothetical company with a small, but growing dividend. I’ll be looking to answer these questions:

  • How much annual growth (percentage) is required for a small dividend to overtake a large dividend?
  • How much time does it take for a small growing dividend to overtake a large dividend with no growth?
  • How long does it take to amass more money from the smaller, growing dividend?

This first graph shows the total return over time for companies with no growth, if you were to reinvest their dividends in full.

In contrast, the following graphs show the same thing, but if a company where to have a lower initial dividend return in the first year, but experience growth in the following years. The first graph shows an initial dividend of 1%, the second shows 1.5% and the third shows 2%.

Note: The following 3 graphs use a log scale because the growth was too big to fit on a chart with a standard scale.

As you can see, depending on your timeframe, you may be better suited to either a higher initial dividend with no growth (accepting that this will never make you rich but will get you more money in the short term [excluding profit from the sale of the stock at the end of your investment period]), or a high growth stock with a lower initial dividend (giving you less dividends in the short term).

I apologise, the log scale makes it very hard to compare. Looking at the data, it seems to me that if your investment period is less than a decade, and you’re only interested in dividend income, then you’re better to take a high paying dividend stock (5% after tax or more).

If your investment period is over a decade and you don’t mind not having much income from the investment for the first decade and a bit, then you’re better off taking the growth stock – especially if your investment period is closer to 20 years, because this will pay off very, very well.

Of course, if you don’t need the income and your investment period is less than a decade, you’re probably better off going for the growth stock and selling it to make more money.

If you are approaching retirement and need an income in future, but not immediately, this graph might help you reach your dividend income goals and get rich with the longer timeframe. This graph shows the dividend growth over time (relative to initial purchase) for a growth stock on a starting dividend of 1.5%.

Finally, this graph shows the initial dividend required for dividend growth to be comparable across stocks with different growth rates (which may help with a valuation if the companies all pay out the same percentage of their earnings as dividends, though this would be a pretty bad way to do a valuation).

Note: The higher growth stocks in the list start to become exponentially higher than the others beyond 15 years.

Obviously this is all just an exercise in theory, because most folk wouldn’t buy a growth stock with view to living off the dividends in 20 years, because things change. Stocks that were growth stocks could have headwinds 2 years into the future, get bought out, change strategy, run out of space to grow in the market they operate in, etc.

I initially set out to find out if a dividend growth stocks are a better strategy to get a dividend income than stocks with large dividends that don’t grow. I didn’t find what I expected, I expected the growing dividend to outpace the stock with no growth within a decade.

I also ended up proving some other things, which is pretty cool. I think the key takeaways here are:

  • Stocks that don’t grow won’t make you rich with dividends
  • Unless you can afford to live off the initial (current) dividend, growth stocks probably won’t provide you with a liveable income within a decade
  • Dividends are irrelevant if you are not currently investing for an income stream. To rephrase that, dividends should not influence your investing decision unless you’re investing to get an income from dividends
  • Change is inevitable – giving rise to risk to your dividend income if you experience a black swan event.

All this makes me wonder if the best income stream you can get from stocks is by only buying growth stocks and selling a portion of your portfolio each year.

Addendum: There is a big assumption in the above logic, which assumes that the growth companies are paying out the same earnings as the non growth company and not investing retained earnings. Obviously this is just theoretical because most growing companies retain most of their earnings and only pay a small dividend (if any).

In the event of a growth company keeping most of it’s earnings, then transitioning to pay out more, this would multiply the dividend many times, making the above graphs irrelevant.

That said I still believe that my conclusions remain relevant. I’d love to hear your opinions in the comments, below.

Categories
Investing

What Is A Good PE?

The Price-to-Earnings ratio (PE) that you are willing to pay for a company should depend on three things: the growth rate of the company, the time frame of your investment and your expected return.

If you are happy with 5% annual return on investment (ROI), assuming either the company pays out 100% of it’s earnings in dividends, or you perceive the value to be retained in the company to be part of your return, a PE of 20 is what you should strive for (5% being the whole company divided into 20, or 100 / 20 = 5).

If a company has zero growth and this is always true, a PE of 20 will eternally get you your 5% ROI. But if the company is growing, and you pay a PE of 20, then each year the PE will improve on the former year (inflation excluded). This is where the other part of my statement comes into play, whereby the growth rate and time frame of your investment will effect the PE you need to pay to get a PE of 20 within your given time frame.

In other words, if you are happy with a PE of 20, but don’t mind waiting a year for the price you paid to become a PE of 20 after a few years growth, you would be willing to pay a PE of greater than 20 to get a better return in years to come.

For example, if you pay $100 for a share of a company that has $4 worth of Earnings Per Share (EPS), you’ve paid a PE of 25 (100 / 4 = 25). If that company grows EPS to $5, you effectively paid a PE of 20 (100 / 5 = 20). If you’re investment time frame is a few years, you might be happy to wait for the PE to take a year to get to an acceptable level, especially knowing that years after, with more growth, your effective PE would be much less than 20.

Here are 3 graphs I’ve created showing how PE changes over time based on an initial purchase at a specific PE for companies with different annual growth rates. The different graphs show how a higher purchase price extends the time frame for the investment to become acceptable.

This should help calculate a good PE to buy shares at, based on your expected ROI, time frame and the growth rate of the company.