Published September 23rd, 2016 by Kay Ng
This is a guest contribution written by Kay Ng who writes on Motley Fool Canada and also writes on Seeking Alpha under the alias Canadian Dividend Growth Investor. She also maintains a blog at Passive Income Earner with a focus on dividend investing as a Canadian investor in Canada and the U.S.
We’re always looking for ways to save and earn more from investing. So, you’ve probably contemplated over whether to invest in a high growth (but low yield) dividend stock such as Nike Inc (NKE) or a slower growth (but higher yield) dividend stock such as Wells Fargo & Co (WFC).
Here are some questions and answers that will help you decide.
Do you need income now?
If you are a retiree, you obviously would prefer a high yield stock. Wells Fargo’s yield of 3.3% doesn’t seem like much, but it’s 2.75 times that of Nike’s yield of nearly 1.2%.
So, a $10,000 investment in Wells Fargo would yield an income of $330 a year. On the other hand, a $10,000 investment in Nike would only yield close to $120 a year. Wells Fargo is one of Warren Buffett’s 20 highest yielding stocks.
What if you have many years to let your investments grow?
If you have decades to let your investments grow, you likely have your eyes set on your future income stream, instead of today’s income.
In that case, Nike may be the better choice for you. Here’s why.
Dividend growth depends on earnings growth. The faster earnings grow, the faster your investment grows (given all else equal).
The consensus analyst opines that Nike will grow its earnings per share (EPS) by about 14% per year in the next 3-5 years.
Throwing in Nike’s yield of about 1%, it means that if Nike’s price-to-earnings ratio (P/E) remains more or less the same, an investment today can be expected to double in a little less than 5 years. Here’s how to double your money.
On the other hand, the consensus analyst opines that Wells Fargo will grow its EPS by 7.8% per year in the next 3-5 years. Throwing in Wells Fargo’s yield of about 3%, it means that if the bank’s P/E remains more or less the same, an investment today can be expected to double in less than 7 years.
Does dividend growth really depend on earnings growth?
Continuing to use Nike and Wells Fargo as examples, let’s look at their historical earnings growth and dividend growth.
Nike has increased its dividend for 14 consecutive years. In the last decade, it grew its EPS at a compound annual growth rate (CAGR) of 12.4%. In the same period, it increased its dividend at a CAGR of 16.3%. The dividend growth was attributable to the double-digit earnings growth and some payout ratio expansion.
Unfortunately, Wells Fargo cut its dividend in 2009 due to the financial crisis. Thankfully, aggressive dividend growth followed in the subsequent few years and the bank recovered its dividend to higher than pre-crisis levels by 2011.
More importantly, what can investors expect from the future dividend growth on these two companies?
The payout ratio tells us the portion of earnings paid out as dividends. So, a lower payout ratio implies a safer dividend and potentially higher dividend growth.
Earnings growth will lower the payout ratio, so higher earnings growth will likely lead to higher dividend growth given the management has shown a willingness to grow the company’s dividend. The dividend growth streak gives a clue about management’s willingness. Ben Reynold put together a list of 50 companies that has grown their dividends for at least 25 years for your convenience.
Nike’s payout ratio is about 28%, while Wells Fargo’s payout ratio is about 38%. If both companies maintain their current payout ratios, their dividend growth will depend solely on earnings growth.
Assuming investing the same amount in Nike and Wells Fargo, since Nike has a higher expected earnings growth rate, the annual dividend that it pays will eventually exceed that of an investment in Wells Fargo. However, it will take a long time for Nike’s dividend income to catch up.
For illustrative purposes, if Nike’s dividend growth aligns with its expected earnings growth of 14% per year, it’ll take Nike just over 19 years to catch up to the yield on cost in an investment in Wells Fargo. This is assuming Wells Fargo grows its dividend by 7.8% per year. Of course, these are all projections and the future is unlikely to happen this way.
However, this illustrates that if income is your focus, moderate yield companies such as Wells Fargo, with moderate growth of its dividend can be very powerful.
What about total returns?
On the other hand, if total returns are your primary objective, Nike will likely deliver higher returns over time because of its higher earnings growth projections.
Other than the company’s ability to execute and deliver growth, another important factor that affects total returns and the initial yield for that matter is valuation.
Typically, the lower the valuation you buy a company, the higher expected returns and starting yield you can expect relative to the company in consideration.
At about $55 per share, Nike trades at a forward P/E of 23. Depending if you think that’s a low enough multiple to pay for 14% growth, you might buy some Nike shares at current levels and buy more if it dips lower.
At under $46 per share, Wells Fargo trades at a forward multiple of 11.4, which is a decent valuation to pay for an expected 7-8% growth.
Investors need to determine if current income, future income, or total returns are their primary investment objective.
If current income is your main objective, look for quality companies, such as Wells Fargo, which are priced at fair to discounted valuations and have decent yields, growing earnings, and sustainable payout ratios.
If future income is more importantly to you, and you have decades for your investments to compound, look for higher growth companies, such as Nike, which are growing their dividends at a double-digit rate.
If total returns are your primary objective, there can be multiple ways to go about it, including investing in moderately to super undervalued dividend stocks. If these companies grow at a high rate as well, the investment ideas can turn out to be very profitable.
Keep in mind that there’s nothing stopping you from owning great companies (whether they’re high growth with a low yield or slower growth with a higher yield). It helps for investors to decide for their purposes which dividend stock is the best buy at any one time.