Finding the right balance between dividend growth and dividend yield can be very difficult. If dividend growth is too low, the impact of inflation means that the real value of your dividends will fall.

On the other hand, a high growth rate from a low yield may mean that your returns simply aren’t worthwhile.

In this article I’ll look at two quite extreme dividend stocks, ARM Holdings (LSE: ARM) and BP (LSE: BP):



ARM Holdings

2016 forecast yield



10-year average annual dividend growth rate



Will BP cut its dividend?

BP’s chunky 7.7% forecast yield is attractive, but this payout is almost unchanged from 10 years ago, thanks to the Gulf of Mexico disaster and the oil crash.

What’s more, BP’s $0.40 per share dividend isn’t expected to be covered by the firm’s earnings in 2016 or in 2017. Maintaining this payout may require the use of borrowed money. Indeed, some investors believe that BP should already have cut its payout.

I suspect that BP will manage to avoid a dividend cut. One reason for this is that an oil supply crunch could hit the market sooner than expected, driving up oil prices. It’s impossible to predict when this will happen, but what we do know is that massive industry spending cuts are starting to have an effect.

US shale oil production is falling steadily. Drilling rig counts in the US have fallen by 55% over the last year. Because shale wells have a relatively short producing lifespan, I expect to see increasingly rapid falls in US oil production over the next six to 12 months. This could result in the oil market rebalancing more quickly than expected, despite the current glut of oil.

Oil companies such as BP have made big cuts to their operating costs over the last couple of years. A sharp rise in oil prices would result in a big surge in profits, lifting the share price and normalising BP’s dividend yield.

Isn’t that a gamble?

By owning BP shares, I’m effectively betting that the price of oil will rise over the next couple of years. If I’m wrong, I may end up wishing I’d invested in ARM Holdings instead. ARM’s dividend sits at the other end of the scale from BP’s payout.

Despite rising by an average of 24.3% per year over the last 10 years, ARM’s dividend has always been generously covered by the firm’s free cash flow. Given ARM’s operating margin of 42% and forecast earnings per share growth of 46% in 2016, this is unlikely to change. The problem is that a yield of 1% just isn’t enough for most income investors.

ARM could afford to pay out more to shareholders. The group has a net cash balance of £950.9m and generated £360.7m of surplus cash last year. Despite this, the firm’s 2015 dividend payout totalled just £123m.

ARM says that dividend payouts are limited in order to make sure that funds are available to increase R&D spending and make acquisitions. The group hopes to expand into new sectors and deliver significant sales growth by 2020.

In my view, this growth potential is ARM’s main attraction. For income investors, the yield is too low — but as a growth play with income potential, I think that ARM remains an exciting long-term choice.

However, both BP and ARM are quite extreme income stocks.

In reality, it's often possible to enjoy better returns by targeting yields that are closer to the market average, but have strong growth potential.

One company that could fit this description is the stock featured in A Top Income Share From The Motley Fool. The Motley Fool's experts believe a sharp rise in profits could be on the cards for this firm.

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Roland Head owns shares of BP. The Motley Fool UK has recommended ARM Holdings and BP. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.