Just because a stock pays a dividend, it doesn't mean that its growth days are behind it. Apple
Let's say that a firm has $100 in capital and income of $10, for a return on capital of 10%. If it pays out 70% of earnings as a dividend, it would pay a $7 dividend and keep $3 as additional paid in capital. The next year, capital starts out at $103, and if we assume that the firm earns a 10% return on capital again, earnings would grow to $10.30 for 3% earnings growth.
The more earnings the firm keeps, the greater the capital base and the faster earnings will grow. For example, if the payout ratio had been only 20%, the capital base would have grown to $108 and the 10% return on capital would result in earnings of $10.80, for 8% earnings growth. Of course, the higher the payout, the higher the current dividend yield is likely to be.
Because utilities companies typically have steady capital needs with few growth opportunities, they tend to have high payout ratios and higher dividend yields, while tech firms have historically had low payout ratios as they often have many growth opportunities.
Now or later?
So which is better: stocks that pay a modest dividend but offer the promise to grow that dividend in the future, or stocks that pay out most of their earnings as dividends with seemingly little potential for growth? There are pros and cons to both approaches.
Dividend growth companies are often higher quality with disciplined managers focused on stable dividend growth. The ability to increase dividends through thick and thin suggests a management culture very concerned about protecting and growing dividends. This is a good signal for future growth, as it keeps managers focused on allocating capital wisely. Warren Buffett is widely known as a dividend growth investor.
A counterargument is the fact that while growth sounds appealing, that growth is often priced into the value of the stock. Additionally, the current economic environment is characterized as having low growth, so reinvested dividends may not earn high rates of return.
Providing arguments in favour of a high payout are academic studies showing that higher payout ratios actually predict higher future earnings growth, both at the aggregate stock market level and at the individual company level. Perhaps what is more important than the payout ratio itself is the information signal from management. Managers who are confident in their business prospects and see strong cash flow in the future are more likely to pay out a large dividend.
Whether you prefer stocks with high payouts or stocks with growth potential, the fund structure is an excellent way to invest in dividend-paying stocks because of its potential for low-cost diversification. There are funds available that focus on higher-payout stocks as well as funds that focus on dividend growth. Dividend-themed funds have been a popular choice for fund investors over the past several years, as dividend yields look attractive relative to bond yields.
Within the Canadian ETF landscape, perhaps the greatest example of the contrast in style between dividend growth and high current yield is iShares Canadian Dividend Aristocrats
Currently, CDZ offers a market-like yield of 3.2%, compared to XDV's 4.1% yield. Stocks in CDZ have a price/earnings ratio of 14.2 times, a sales growth rate of 5.8% and a book value growth rate of 5.7%. Stocks in XDV have a price/earnings ratio of 12.3 times, a sales growth rate of 2.1%, and a book value growth rate of 3.0%. Clearly, stocks in CDZ are growing faster than stocks in XDV, but they are also more expensive, selling at a higher valuation multiple.
Over the past five years, CDZ has returned 3.4% per year, trouncing the 1% return of XDV. Both funds posted standard deviations of 15% over the period. Part of the outperformance of CDZ can be attributed to its lower allocation to financial stocks through the financial crisis. XDV parks about 55% of its assets in the financials sector, versus just 20% in CDZ. There's also a notable small-cap tilt to CDZ, as it sports a holdings-weighted average market capitalization of $3.5 billion, compared to $11.7 billion for XDV.
--John Gabriel contributed to this article.