How To Mix Dividend Yield And Earnings Growth To Find Stronger Total Returns

17th Nov '21 by Ben Hobson

15 comments 6053 reads

When it comes to stock market returns, dividend yield is one of two components that determine what you might expect to achieve from owning a share (the other being a change in its price). But yield can also tell you a lot about the nature of the stock and what the market really thinks about it.

A lot of what’s written and reported about dividend yield tends to treat it in isolation: from news stories in the press through to investment books and even entire dividend strategies.

This does make some sense, of course, because dividends are a major source of returns over time. But there is a bigger picture to think about. To pay dividends, companies need stable earnings that are preferably growing. And over time, earnings growth is also a major contributor to rising stock valuation (which ultimately drives share prices).

This means that dividend payouts and capital gains are two sides of the same ‘return’ coin. They are intertwined. Even if you insist on prioritising dividends, ignoring questions like whether a company is capable of growing its earnings, can eventually leave you exposed to ‘dividend traps’.

What’s preferable is to approach capital gains and yield together, and focus on what’s known as total return.

In this article I’m going to explore the role of yield in investing, how it contributes to total return and how you might choose to use it in your own strategy.

Understanding the appeal of high yield

First, here’s a primer on what yield is and how different variables can influence it...

Yield is used as a measure of return in a variety of different asset classes. With shares, it’s a measure of the cash returns (dividends) that companies make to their shareholders. They pay dividends from their net earnings, or net profit. This is the same profit pot that they can either retain or reinvest in themselves, or use to fund share buybacks.

To calculate a dividend yield, divide the company’s dividend-per-share by its share price and multiply that by 100.

For example, if a stock is paying 10p per share in dividends and has a share price of 500p, then the dividend yield will be 2.0% (10 / 500 x 100 = 2).

Paying dividends can be a sign of maturity in a business, but it’s not always defined by size. It’s…

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jmallin1972

17th Nov '21

Another interesting and well written article Ben.

Silver Moon

Thanks Ben, I do like this as I need to lean my portfolio away from speculative non-dividend payers.

Anthony127

18th Nov '21

I think it is a good idea for investors to focus more on dividends. People usually underestimate how much of their investment returns are due to dividends and also do not appreciate how much return is due to the reinvestment of dividends.

In terms of safety I would suggest a further metric to take into account; which is that Operational Cash Flow per share is greater than EPS. This helps to ensure that the earnings are real and not caused by accounting sleight of hand. This will add confidence to the Dividend Cover ratio. It is possible to manipulate earnings but cash is real.

gus 1065

Excellent write up, thanks for this.

At risk of sounding like a broken record, it would be great if the portfolio tools on Stocko would provide an option to accumulate dividend income automatically based on reported dividend, number of shares held and dates of purchase sale. I hold over 200 individual shares many of which pay dividends twice a year and I’ve long since given up trying to log them manually in my portfolio which gives me an inaccurate real return figure over time and distorts the relative performance of the payers vis the non payers.

Gus.

AnonymousUser1822519

Thanks. Another one to add to my screens. Its not just the screens that are good but your explanations which when it comes to fundamentals even a laymen like me can understand. Would be great if you would consider doing a GARP(Growth at a Resonable Price) screen at some point. There is already one in the GURU screens, but that one doesnt come with your teachings.

FREng

Gus

It has often been said that the more different shares one owns, the more it makes sense just to buy a tracker fund or ETF. I have never attempted to check the truth of this (though it sounds logical, as each additional share one buys adds less and less to the overall portfolio performance).

Do you have any data that would help me to understand how well an individual with a large number of shares can do compared with a diversified ETF or a few ETFs? Have you compared your portfolio's performance against any ETFs or funds?

Hi FREng.

I have to confess that I’m not especially disciplined in benchmarking my individual stock investments against any particular index or ETF, partly through indolence and partly because I use my various investment accounts for living expenses so there’s a constant ebb and flow in and out of the accounts that makes tracking the underlying performance tricky.

Historically I used to have substantially all of my investments in either funds or ETFs as my job in the City made it virtually impossible to deal in individual shares due to numerous (thoroughly justified) compliance constraints. Since about 2015 when I started using Stocko I’ve developed something of a magpie approach and have gradually grown quite a diversified individual share portfolio in my ISA and Investment accounts while keeping the SIPP in funds/ETFs.

One lesson I learned quite early on was that while I was quite good at picking up on macro themes I wasn’t very good (or at least seemed a bit unlucky!) at picking individual stocks and tended to have too focused a portfolio of about 20 or so shares. Accordingly, I now play a slightly different game where I identify a group of stocks that play to a particular theme and spread my investment across several companies. What I lose from “diworsification” I gain from not having an “Oh s**t” moment with the 7.00am RNS flow. I guess it’s similar to building a range of ETFs of my own design and incurring various costs but keeping any dividends. As a result, while I have a fairly diversified share portfolio (i.e. well over 200 individual shares/ITs), the overall composition is not like any single ETF or Tracker that I’m aware of. Overall it’s pretty much influenced by looking for strong Stocko metrics (a lot of green and neutrals and not too many reds) and certain sectors where I feel I have a better understanding of how these companies work. (Note the Financials segment is exaggerated by including quite a broad spread of Investment Trusts and a few ETFs).

In terms of ongoing performance the long term trend appears to be comfortably above the FTSE All Share Index (based on the Stocko graphic for my portfolio) but for various reasons I’m not convinced of the data’s integrity so don’t set too much store by it. FWIW, here’s a picky of the YTD picture albeit from a base that was already up against the index as I had to import the data from another source to rebuild the file in Stocko.

Iain Wright

20th Nov '21

The suggestion of having dividend accumulated automatically by Stoko is a good one. But, if you’re a spreadsheet user, an alternative would be to download all transactions from your broker account and sort them based on the transaction description. Not for everyone perhaps, but a good alternative if you’re that way inclined

Hi Iain.

That is exactly what I do once a year in April to fill in my tax return but it’s a penance rather than a pleasure and it would be nice to be able to see the figures on the go and also stock by stock to be able to monitor the combined capital and yield return.

Rusty2

I don't understand the logic that adding more shares, will lessen the performance, it is often the other way around. I know people with concentrated portfolios, have been really burnt when a few stocks, have crashed or fallen. Are you saying 10 stocks will outperform 20? Trackers will pick up all shares, so you can check the indexes. There are so many ETFs, how can you compare, some ETFs have done very well, such as certain commodities. I have compared mine to some funds such as Fundsmith which I also hold. Some BG US funds did really well last year but struggling this year.

prem14

Would be great if you could share how the screen looks when you add this new rule.

I’m in two minds about dividends, why pay out dividends to shareholders, instead of investing it in the business? I think this is one reason why larger companies in the UK, struggle to grow, many have large debts as well. Look at the US market, quite a few large caps there, pay no or a small dividend yet they have grown considerably. The other problem is, dividends are not guaranteed, look at last year, many companies stopped or reduced the dividend. I would not buy a stock now because of the dividend, fallen in that trap in the past. Yes if they are paid then they should be included in your folio., although that would make comparisons with indexes difficult.

GN100

23rd Nov '21

Sharescope/pad provide this facility to add dividends automatically. I used it for a while but found it unreliable and I concluded that the only sure way is to add them yourself manually.

29th Nov '21

I am also fairly schizophrenic on the question of dividends.

On the one hand I have evolved into the kind of investor who prefers companies to reinvest their spare cash. Having said that there are certain companies who have no other use for their spare cash because they have easily met their capex requirements and I think this type of company is worth investing in despite being a high yielder.

If you look at 2019 (the last normal year) the total return for the FTSE 100 was 17.1 % of which dividends represented 5.1% i.e. a contribution of nearly 30%. When you add in the compounding of the reinvestment I think it is definitely worth looking into.

The main question for me is whether enrol into a dividend reinvestment programme (drip) for any high yielder I own or whether to continue to enjoy the liquidity it provides and purchase other shares?

jjis

On the question of reinvesting dividends - I think it is a great idea to benefit from Compounding if you don't need the income. Personally I always let them accumulate and then reinvest when it has either built up or when doing other transactions.

I am a big fan of dividends plus compounding & would agree with much of the detail that Ben kindly shared. Personally I like to look at yield with other value metrics, dividend cover by both earnings and cashflow, dividend growth streak and forecast, estimate revisions plus the quality and financial security of the Company / business producing the dividends. I don't generally chase the highest yielder on that basis.

I produce my own Scores of all UK dividend paying companies based on the above inputs to see how they rank within that universe as personally as I live off of my investments & I'm not interested in zero payers, although accepting that this means I might miss out on some winners that do not pay dividends. I find this preferable to screening which tends to only throw up a short list of names.

This has been very successful for me in the last 5 to 6 years.

How to mix dividend yield and earnings growth to find stronger total returns

Understanding the appeal of high yield

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Ben Hobson

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