There are 422 dividend paying stocks in the S&P 500 Index, but not all are created equal.
To use a job analogy, some jobs offer a good upfront salary and stability in income, however, upside growth is limited. While other jobs may have lower starting salaries, they make up for it with growth opportunity and, in some cases, unlimited upside through bonuses or commissions.
Which job is more appealing to you?
Similarly, there are some dividend-paying stocks like utilities (electric, gas and water utility companies) that pay a higher than market average dividend and offer good stability of both income and underlying stock price.
However, most utilities don’t offer much upside growth. The average utility stock in the S&P 500 Index pays a dividend yield of 3.80 percent versus the 1.80 percent overall average dividend yield of the broad index.
Conversely, utility companies on average have grown their earnings per share over the last five years by a negative 3.40 percent as opposed to the index average five years earnings per share growth of a positive 9.64 percent.
The net result is more income, less growth. In the last 10 years, since 2004, utilities on average have grown in price 83 percent, or about 6.2 percent annualized.
Other dividend-paying companies offer a lower initial yield but better growth of dividends per share each year and better growth of underlying earnings per share, which typically drives the stock price higher.
These companies are referred to as "dividend growth" companies, such as McDonalds and IBM.
McDonalds pays a dividend of $3.12 per share, which at recent prices equates to a yield of 3.4 percent. It has grown its dividend over the last 10 years from less than $0.50 per share to over $3.00 per share. During that same time, McDonald’s stock price has grown from less than $30 per share to over $95 per share today. This represents a price-only increase of about 230 percent since 2004, or about 12.7 percent annualized (double that of the average utility stock).
If you add in the dividends you received from McDonalds over the last 10 years to the growth in the price of the stock, your total combined return would have been 345 percent, or about 16 percent annualized.
So if you had started in 2004 with $10,000, your investment would have grown with just price appreciation to about $23,000. However, when you add in dividends, your combined total return would have grown your $10,000 investment to $34,500; that’s $11,500, or about 50 percent more than just price appreciation alone. That’s the power of regular income payments, growth and compounding.
So which type of dividend stock is right for you? Well, back to the job analogy, you may ask yourself which “job” mentioned above would make you happier at this point in your life; stability and low risk or a moderate current income with attractive growth opportunities? Generally, if you want lower risk and higher income, utilities are usually a good bet. However, if you want moderate income with growth then dividend growth stocks may be best for you.
Either way, seeking the advice of a professional investment adviser is often a prudent first step.
Reed Walters is president and CEO of Sector Capital Management LLC.