The Dividend Yield That Really Matters

Over time, with higher dividend growth, a lower-yielding share can deliver more income — and boast a higher ‘bought yield’.

| More on:

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

Investors starting out on the income investing path sometimes get themselves into a tangle over yield. Accustomed to thinking in terms of conventional savings accounts, they tend to overlook one of the most powerful aspects of investing in shares — the fact that dividends tend to grow over time.
 
As such, while a share’s current dividend yield is an important aspect of income investing, it’s only one aspect.
 
And even after screening out companies with other characteristics that you might not like — high debts, low dividend cover, a too-high price-earnings ratio (P/E) and so on — it’s always useful to compare a company’s current dividend yield with the growth that it has delivered in its dividend payouts over time.
 
Projecting that growth into the future gives you a handy clue as to what you might expect by way of bought dividend yield — in other words, not the current dividend yield, but the yield figure that actually relates to the price that you paid for a share.

Yield: dividend over share price

But first, let’s step back and remind ourselves of the basics.
 
Dividend yield is easily calculated — it’s the figure you see in newspapers, and on websites.
 
That said, the yields quoted on some websites can occasionally be wrong — Google Finance, for instance, can be thrown by quarterly dividend payouts, and payouts reported in currencies other than pounds sterling.
 
At the time of writing, for instance, Google is telling me that Royal Dutch Shell is yielding 0.9%, and not the 5.8% that is actually correct.
 
So if a company’s shares are priced at 100p, and its most recent annual dividend was 5p, then the dividend yield is of course 5%. That 5p might have been spread out over an interim half-year payout of 2.5p and a final full-year payout of a further 2.5p, but the key thing is the total paid out in a year.

3.9% vs. 3.3%

So let’s plug some real companies into the calculation, and see what emerges.
 
As an income investor, we might like the look of defence contractor BAE Systems (LSE: BA), for instance, which — at the time of writing — offers a yield of 3.9%. That’s a fifth higher than the yield offered by the FTSE as a whole, and of course massively higher than the payout from a conventional savings account.

But is it the best income share on offer in that aerospace and defence sector? The industry isn’t one that is particularly crowded, and so our eyes might alight on FTSE 250-listed Cobham (LSE: COB), which at a dividend yield of 3.3% is offering virtually the FTSE’s average dividend yield.
 
So is BAE Systems is the better income share? It certainly looks to be, as it offers a yield of 3.9% versus Cobham’s more pedestrian 3.3%.
 
Not so fast.

High yield, low growth vs. low yield, high growth

This is where dividend growth comes into play. Back in 2010, BAE Systems declared dividends totalling 17.5p. In 2014, the figure was 20.5p. That’s a compound growth rate of 4.0%.
 
But over at Cobham — which is noted for steadily growing its dividend, and even managed to do so during the 2007-2008 recession — the picture is rather rosier.
 
Cobham’s declared dividend for 2010 was 6.0p and 10.65p for 2014. That’s an altogether meatier compound growth rate of 15.4% — a tad higher than the company’s 13.5% growth rate over the longer 2005-2014 timescale.

Over time, ‘bought yield’ matters

So which looks the better bet for an income investor now? On the assumption that Cobham can continue a dividend growth rate that stretches back to 2005 and beyond, the answer has to be Cobham.

Because while the income from BAE Systems is higher to begin with, the payouts from Cobham soon outstrip it — doing so in just two years, in fact. And after five years, the income from Cobham will be 40% higher than the income from BAE Systems.
 
At which point, the ‘bought dividend yield’ on Cobham — that is, the current dividend with reference to the price originally paid for the shares — will be 6.7%, versus 4.7% for BAE Systems.
 
After ten years, the difference is even greater. Assuming that both companies maintain their dividend growth rates, an investment in BAE Systems will have a bought yield of 5.8%. At Cobham, it’s a juicy 13.8%.
 
Newspapers and websites, of course, will still be quoting the current dividend yield, based on the current share price and current dividend. And quite possibly, Cobham will again be the share with the lower current yield.

Ice the cake with a value entry point

And yet, as you’ll read in the disclosure statement below, among the shares that I own are Royal Dutch Shell and BAE Systems, but not — as yet — Cobham.
 
Why?
 
Greed is the answer. Since mid-2012, I’ve been waiting for Cobham shares to present a more attractive entry point. And while they’ve come close, so far no banana. 

That could change — and the share price has been drifting downwards in recent weeks. At which point, I’ll buy.

Which, I guess, makes me an income investor with a bias towards value. But that’s another story.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Malcolm owns shares in Royal Dutch Shell and BAE Systems. 

More on Investing Articles

Mature couple at the beach
Investing Articles

6 stocks that Fools have been buying!

Our Foolish freelancers are putting their money where their mouths are and buying these stocks in recent weeks.

Read more »

Black woman using loudspeaker to be heard
Investing Articles

I was right about the Barclays share price! Here’s what I think happens next

Jon Smith explains why he still feels the Barclays share price is undervalued and flags up why updates on its…

Read more »

Investing Articles

Where I’d start investing £8,000 in April 2024

Writer Ben McPoland highlights two areas of the stock market that he would target if he were to start investing…

Read more »

View of Tower Bridge in Autumn
Investing Articles

Ahead of the ISA deadline, here are 3 FTSE 100 stocks I’d consider

Jon Smith notes down some FTSE 100 stocks in sectors ranging from property to retail that he thinks could offer…

Read more »

Young female business analyst looking at a graph chart while working from home
Investing Articles

Why I think Rolls-Royce shares will pay a dividend in 2024

Stephen Wright thinks Rolls-Royce shares are about to pay a dividend again. But he isn’t convinced this is something investors…

Read more »

Investing Articles

1 of the best UK shares to consider buying in April

Higher gold prices and a falling share price have put this FTSE 250 stock on Stephen Wright's list of UK…

Read more »

Person holding magnifying glass over important document, reading the small print
Investing Articles

The market is wrong about this FTSE 250 stock. I’m buying it in April

Stephen Wright thinks investors should look past a 49% decline in earnings per share and consider investing in a FTSE…

Read more »

Black father and two young daughters dancing at home
Investing Articles

1 FTSE 250 stock I own, and 1 I’d love to buy

Our writer explains why she’s eyeing up this FTSE 250 growth phenomenon, and may buy more shares in this property…

Read more »