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The Case for Dividend Growth Stocks

 

Would you like to buy a stock earning a 6.9% dividend?  A dividend that can be expected to grow each year?  If you are willing to plant a seed and let it grow for a few years, you can do just that.  The key is to buy a good company which is paying a dividend which will grow in the coming years and then to measure that yield on your investment, rather than on the market.

 

Suppose you buy a stock paying a 2.5% dividend where that dividend is growing at 12% and is expected to continue that rate of growth.  For a $100,000 investment, the first year you will receive $2,500 in dividends.  By year five, you will receive almost $4,000 and by year ten, over $6,900.  That represents a 6.9% yield on your investment (not a current yield).

 

This is the idea behind buying stocks which both pay a dividend and are expected to grow that dividend:  it is a way to receive current income and to grow that income yearly without being fully subject to the vagaries of current interest rate levels.

 

Another way to see the benefit is to compare that stock to a government bond paying 4.5%.  For an investment of $100,000, the bond will pay $4500/year every year until its maturity at which point you will receive $100,000 to reinvest at whatever the current interest rates are at that time.  The stock will pay $2,500 the first year and by year five will be paying about $4000/year.  By year five, the stock will have paid just under $16,000 and the bond $22,500.  Of course, we don't know what the stock will be worth.  If it has indeed grown its dividend by 12% annually and interest rates are at the same levels, chances are that its current yield will be around the same 2.5%.  This means that the value of the stock would be $157,000, an increase of 57% or 9.4% annualized.  Compare this to the bond which, in a stable interest rate environment would be expected still to be worth $100,000. This is summarized in the table below:

 

$100,000 investment

10 year bond

Stock

Current yield

4.5%

2.5%

Estimated growth of yield

0%

12.%

First year income

$4,500

$2,500

Fifth year income

$4,500

$4,000

Total income first 5 years

$22,500

$16,000

Estimated market value at constant yield

$100,000

$157,000

Sum of income + estimated market value

$122,500

$173,000

 

The changes in tax law bringing the federal tax rate on most dividends down to 15% has brought a lot of attention to investing for dividends.  This is really an added benefit.  The real reason to invest for dividends is that this is one source of income that can grow year to year.

 

Certainly any investment carries risks, including this strategy.  Any stock investment risks loss of principal.  In addition, if you are buying a company for its dividend yield, you risk a loss of income and principal if the dividend is reduced.  We address these risks by assembling a portfolio of these companies across various industries.  We pay close attention to how much of their earnings they are paying out in dividends:  the lower the better since, if earnings hit a bump and decline, there will not be a commensurate need to reduce the dividend.

 

Independence Trust Company offers a portfolio of stocks such as these for its clients.  If you have interest in finding out more about this or our other services, please contact us at 615.591.0044.


Disclosure:  The example above assumes an investment period of five years and does not represent the results of actual client investments and/or trading but rather is simply an example to illustrate the combination of dividend income and growth.  Your actual investment may not perform in the same manner as this example.  The use of an example presents inherent limitations since it does not reflect actual trading or the impact of material economic and market factors on decision-making process for actual client accounts.  Material market and economic conditions may have a positive or negative impact on the sample returns presented in our example.  Past performance is not an indication of future performance.  Advisory fees, commissions and other client expenses would reduce the returns presented in our example.

 

This information has been prepared by Independence Trust Company to highlight issues which may be of interest to the recipient and is not intended as legal, investment or tax advice. You are urged to seek legal, tax and accounting counsel for your particular situation before acting on topics discussed here. At Independence Trust Company, we assist our clients in managing and enhancing their wealth.  Please call us at 615.591.0044 with questions or to schedule a meeting.  © 2005 Independence Trust Company

 

Independence Trust Company

P.O. Box 682188

Franklin, TN   37068-2188

www.independencetrust.com

615.591.0044

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