Dividend investors often set minimum requirements for an “acceptable” initial dividend yield and/or dividend growth rate when they are considering buying a dividend stock.
Thus one investor might say, “I won’t invest in a dividend stock with a starting yield less than 3%.” Another might say, “I want a minimum 10% per year dividend increase.”
The goal, of course, is to purchase stocks whose yields and dividend growth rates are high enough to make them better bets than safer fixed-income investments like money market accounts, certificates of deposit, and bonds.
The dynamic that determines the goal of “high enough” is how a stock’s initial dividend yield and annual dividend growth rates interact over time. Obviously, a 6% initial yield will require a lower annual growth rate than a 2% initial yield to achieve a given return within a given time. By the same token, a 6% initial yield will get to a given return faster than a 2% initial yield for any given rate of growth.
Most dividend investors have a long-term holding period in mind when they buy dividend stocks. They are not looking to trade them often, but rather to hold them, allowing time for the dividends to increase and compound, until the stock itself becomes a money-generating machine irrespective of the stock’s price fluctuations.
Here is a useful way to look at this:
Look for stocks that will achieve a 10% dividend return on your original investment within 10 years’ time. I call this the “10 by 10” approach.
The two 10’s are arbitrary, of course. You can put in any goals you like. I chose 10 and 10 because:
10% is a healthy rate of return, almost equal to the long-term total return of the stock market itself, which most studies show is between 10% and 11%. (Total return includes price appreciation as well as dividend return.)
10 years is a useful time frame for people of most ages. Young people, of course, have a much longer investment timeframe, but nevertheless may consider 10 years long enough to wait for the kind of return they are seeking. Older people—say in their 60’s and 70’s—still often think in terms of timeframes at least as long as 10 years, since just by having lived to their current age, their life expectancy usually is longer than 10 years from right now.
And, of course, 10 is a nice round number. It is easy to think in terms of 10% return and a 10-year timeframe to get a good grasp of the underlying principles.
So the question becomes simple:
What initial yields, compounded at what rates of growth, achieve 10% return within 10 years?
The following table answers that question. It shows initial yields (across the top) and annual growth rates (down the side). Where any two values intersect, the table shows how many years it takes to achieve a 10% dividend return. Beneath the table are a few notes on calculation and interpretation.
The faster you hit your 10% dividend return rate goal, the fewer years that your stock choice is subject to prediction risk—that is, the risk that you overestimated its rate of dividend growth. As all dividend investors know, their initial rate of return is fixed at the time of purchase, but the future rate of dividend growth is somewhat speculative. Also, the higher the rate of projected dividend growth, the lower the probability that it will actually be achieved. Getting to your goal in fewer years is generally better all around.
http://www.dividendgrowthinvestor.com/2008/11/10-by-10-new-way-to-look-at-yield-and.html
