Dividend growth versus high yield: yield on cost and the twenty-year maths
Compare a low-yield, fast-growing dividend with a high, slow-growing one using yield on cost, cumulative income and total return over twenty years.
What you will learn
- How to calculate yield on cost and the dividend growth rate from a company's dividend history.
- Why a 2.5 percent dividend growing at 8 percent can overtake a 6 percent dividend within about thirteen years.
- How dividend yield and dividend growth combine into an expected total return.
- Which investor profile suits each approach, and why neither is "free money".
Explanation
Dividend yield and payout ratio basics were covered in the course Stocks & Fundamental Analysis; here we compare two income strategies with numbers.
Dividend yield is this year's dividend per share divided by today's share price. Yield on cost (YOC) is this year's dividend per share divided by the price you paid. If you bought at €100 and the dividend has grown from €2.50 to €5.00, your yield on cost is 5 percent, even if the current yield for a new buyer is still 2.5 percent because the price doubled too.
The dividend growth rate (DGR) is the compound annual growth rate of the dividend per share. For a dividend that rose from €1.00 to €1.47 in five years, the DGR is (1.47 / 1.00)^(1/5) − 1 = 8.0 percent. Always use the dividend per share, not the total amount paid, because buybacks change the share count.
A dividend-growth strategy buys companies with a modest yield (often 1.5 to 3.5 percent) and a long record of raising the dividend faster than inflation. A high-yield strategy buys companies with a yield well above the market average (often 5 percent or more), accepting little or no growth.
The useful link between the two is the Gordon growth model: under simplifying assumptions, the expected annual total return of a share is roughly its dividend yield plus its long-run dividend growth rate. A 2.5 percent yield with 8 percent growth implies about 10.5 percent; a 6 percent yield with 1 percent growth implies about 7 percent. This is an expectation, not a promise: growth can stop, and high yields often signal that the market expects a cut (lesson 3).
Worked example
Hypothetical example: you invest €10,000 in each of two shares at €100 per share, so 100 shares each. Fees, spreads and taxes are excluded; dividends are not reinvested unless stated.
| Share A (growth) | Share B (high yield) | |
|---|---|---|
| Dividend per share, year 1 | €2.50 (yield 2.5%) | €6.00 (yield 6.0%) |
| Assumed dividend growth rate | 8% per year | 1% per year |
| Dividend per share, year 10 | €2.50 × 1.08^9 = €5.00 | €6.00 × 1.01^9 = €6.56 |
| Dividend per share, year 20 | €2.50 × 1.08^19 = €10.79 | €6.00 × 1.01^19 = €7.25 |
| Yield on cost after 20 increases | €2.50 × 1.08^20 / €100 = 11.65% | €6.00 × 1.01^20 / €100 = 7.32% |
| Cumulative dividends, 20 years (per €100) | €2.50 × (1.08^20 − 1) / 0.08 = €114.40 | €6.00 × (1.01^20 − 1) / 0.01 = €132.10 |
Step 1 – crossover year. The annual dividend of A overtakes B when 2.50 × 1.08^n = 6.00 × 1.01^n. Solving: n = ln(6.00 / 2.50) / ln(1.08 / 1.01) = 0.875 / 0.067 = about 13 years. Until then B pays more each year.
Step 2 – cumulative income. Even after twenty years, B has paid more in total (€132.10 versus €114.40 per €100 invested) because of its head start. The growth strategy only wins on cumulative income after roughly year 25 under these assumptions.
Step 3 – total return. Assume each share keeps its starting yield, so the price grows at the dividend growth rate. Share A ends at €100 × 1.08^20 = €466; share B at €100 × 1.01^20 = €122. Adding cumulative dividends: A delivers €466 + €114 = €580 per €100; B delivers €122 + €132 = €254. If dividends were reinvested at the same yield, the compound growth is approximately (1 + g) × (1 + y) − 1: about 10.7 percent per year for A and 7.1 percent for B.
Exclusions: taxes on each dividend, the possibility that growth slows, and the fact that B's higher yield may already reflect a weaker business.
Common mistake
Practice activity
On paper: share C yields 3.5 percent with an assumed 6 percent dividend growth rate. Share D yields 5.0 percent with 2 percent growth. Both cost €100. Calculate (a) the yield on cost of each after ten increases, (b) cumulative dividends per €100 over ten years, and (c) the crossover year for the annual dividend.
Show solution
(a) C: 3.5% × 1.06^10 = 6.27%. D: 5.0% × 1.02^10 = 6.09%.
(b) C: €3.50 × (1.06^10 − 1) / 0.06 = €46.10. D: €5.00 × (1.02^10 − 1) / 0.02 = €54.70.
(c) n = ln(5.0 / 3.5) / ln(1.06 / 1.02) = 0.357 / 0.038 = about 9.3, so C's annual dividend passes D's after roughly nine to ten increases (around year 10 to 11). D still leads on cumulative income at that point.
Limitations: constant growth rates for ten or twenty years are an assumption; real dividends are cut, frozen or raised unevenly.
Key takeaways
- Yield on cost = current dividend per share / your purchase price; it grows with the dividend growth rate.
- Expected total return is roughly current yield plus sustainable dividend growth, not yield alone.
- A high yield pays more for the first decade or more; a growth dividend can overtake it later, but only if growth continues.
- Choose the approach that matches your horizon and need for income today, and remember both carry equity risk.
Next step
Next, lesson 2 shows how to test whether a dividend is affordable by comparing earnings payout, free-cash-flow payout and dividend cover.
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