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If stock prices remain steady and if valuations return to reasonable levels through earnings growth, the best stock allocation for dividend investors will be a toss up.

A dividend investor never sells any shares. He lives off the dividends. Almost always, dividend amounts grow faster than inflation.

At today’s prices, a dividend investor can (with care) get a 4% dividend yield. Assuming that his earnings growth matches the long term growth of the S&P500, his dividend growth will be 1% faster than inflation.

Many dividend investors start out with a lower yield and a better growth rate.

Dividend investors who also hold TIPS receive a steady 2.0%+ real return in the form of interest. Varying stock allocations changes little: 4% initially plus 1% real growth from dividends versus a steady 2% real return.

Computational Details

The earnings yield of the S&P500 index is 100E10/P, where today’s P/E10 is close to 27. The dividend payout ratio in recent times has been 63% of the earnings yield (plus and minus 10%, approximately). High dividend stocks from high quality companies yield 1.7 times as much as the S&P500.

Today’s yield is 3.7%*(0.63)*1.7=4.0% for dividend investors.

The long term real earnings growth rate of the S&P500 is 1.55% per year. Assuming a 63% payout ratio, the long term dividend growth rate of the S&P500 index is 1.0% per year. The growth rate for dividend investors is also 1.0%. [Mathematical detail: the growth rate is normalized to the initial amount. That is, dD/dt is divided by D, where D is the dividend amount.]

Annualized Comparisons

The annualized return r over N years satisfies (1+r)^N = product of all returns. For dividends, the initial term is 1.04 (in year zero). Later returns are 1% or (1.01)^N over N years. After N years, the return is (1.04)*(1.01)^N. To solve for the annualized return, you take the Nth root. That is, (1+r) = [(1.04)^(1/N)]*1.01.

We compare this with the steady 2% real return of TIPS.

If N=4, (1+r) = 1.00985*1.01 = 1.01995. That is, r = 0.01995 = 1.995%.

The return from dividends, when annualized, matches the interest from TIPS at year 4. In this example, dividends have a higher annualized return prior to year 4 and a lower annualized return after year 4. Faster dividend growth rates, possibly at the cost of lower initial dividend yields, can delay this crossover point.

Recap

If stock prices remain steady and if valuations return to reasonable levels through earnings growth, the best stock allocation for dividend investors will be a toss up.

Dividend investors who own TIPS as well as stocks will do well if prices drop faster. They will be able to replace their TIPS with stocks at more attractive yields.

Have fun.

John Walter Russell
December 4, 2006