Why Dividend Growth Matters More than Raw Yield

A high dividend yield is nice.

A high dividend growth rate is ultimately better.

When Ray Dalio speaks, people tend to listen. Dalio is the billionaire founder of Bridgewater Associates, the largest hedge fund management company in the world. And it seems Mr. Dalio has a lot to say these days.

Back in January, Dalio said that “cash is trash” in a CNBC interview, and he repeated that sentiment earlier this month, saying that COVID-19 stimulus measures would eventually ignite inflation and that cash would “not be the safest asset to hold.”

I’d agree and would add that bonds — which pay a fixed coupon rate — aren’t much better.

This reminds me of one of my favorite income metrics: yield on cost.

How Yield on Cost Works

The yield on cost is the current annual dividend or interest income divided by your original purchase price. This isn’t going to be a meaningful metric for a short-term trader, but it’s something every long-term income investor will immediately understand and appreciate.

It’s best explained by example. Let’s compare the yield on cost between a hypothetical 30-year junk bond yielding 5.5% trading at par and Realty Income (O), one of my very favorite income stocks. Realty Income also happens to yield 5.5% at current prices.

We’ll start with the bond: $10,000 invested in the bond will produce exactly $550 per year in income in Year 1. But by year 30, it’s still producing exactly $550 per year. Your yield on cost is no different than your current yield. (We’ll also just ignore the likelihood that a company issuing a junk bond goes bankrupt long before we hit the 30-year market. Work with me here!)

Now, let’s compare that to Realty Income. Since going public in 1994, Realty Income has raised its dividend at a 4.5% compound annual rate. Just for grins, we’ll assume that dividend growth is a little slower over the next 30 years and compounds at just 4%.

In Year 1, a $10,000 investment in Realty Income also pays $550. But after 10 years of compounding at 4.5%, that annual payout jumps to $854.13 per year. After 20 years, it grows to $1,326.44. And after 30 years, it grows to $2,059.92.

$854.13 represents a yield on cost of 8.5%.

$1,326.44 represents a yield on cost of 13.3%

And $2,059.92 represents a gargantuan yield on cost of 20.6%.

Now, there are a couple things to keep in mind here. Yield on cost compares the current payout to the original purchase price. It takes no account of the current stock price, which also would presumably rise over time. Compare that to a bond again. The best you can ever hope to get from a bond at maturity is its original par value.

Also, 30 years is a long time to own a stock and might not be realistic for all investors. I’ve personally owned Realty Income for over 10 years and would like to own it for another 20 years. But I also bought the shares when I was a spry 32 years old.  Had I bought the shares having already reached retirement age, the 30-year yield on cost would be a little ridiculous.

And finally, it’s important to remember that dividends can cut just as easily as they can be raised. We’re getting a stark reminder of that this year due to the COVID-19 business disruptions. Goldman Sachs estimated last month that S&P 500 dividends would drop by 25% this year.

So, you’ll still want some cash and bonds in your portfolio, particularly if you’re in or near retirement. But if Dalio is right, and cash really is destined to become trash, you’ll want to own assets that throw off income streams that keep pace with inflation.