One of the biggest questions any new investor will ask is whether they should invest for dividends or for growth. This will partly depend on your circumstances, but how do these approaches compare for total returns?
Income is one of the advantages of dividend stocks, but if you take all your dividends as income, you miss out on the compounding effect of reinvestment. For example, if you bought a stock that paid a 5% dividend it would take just over 14 years to see a 100% return after reinvestment. However, it would take 20 years to earn 100% if you didn’t reinvest your dividends as you would lose the benefits of compound interest.
By contrast you would probably be hoping for a 100% return in a much shorter time if you invested in growth stocks. The argument for a company offering growth over paying dividends is the belief that you could generate higher returns by reinvesting in the business compared to what it would be able to pay out.
Quality not quantity
When considering dividend stocks it is easy to be attracted to high dividend yields. Unfortunately, a very high yield is often a precursor to a dividend cut as investors sell in expectation of bad news, which lowers the share price, raising the dividend percentage. Therefore it is important to look at both dividend cover and free cash flow per share to make sure that a dividend is safe.
A rule of thumb for well protected dividends is coverage of 1.5x or more by earnings-per-share. It is also important to check that free cash flow per share is greater than the dividend per share or the company will not be able to pay it with taking on debt. If profits are regularly decreasing, then this indicates that dividends are likely to be reduced over time.
There are stocks available that offer both growth and dividends for the ambitious investor. The risk with this approach is that growth stocks can often offer high dividends just as their growth is slowing. This can lead to a correction in the share price as growth investors move their money to new stocks.
Best of both worlds
But one growth stock I like that also offers dividends is Games Workshop (LSE:GAW). I think there’s potential for international expansion because of the encouraging sales growth in America of over 25%. Forecasts for this company are consistently conservative as demonstrated by earnings forecasts being raised three times in the past year. It may be more profitable than forecasts imply. There is a dividend of 4.3% which is covered 1.4x times for the coming year which is less than my rule of thumb, but as I am confident of the growth on offer, I don’t expect the dividend to be threatened by reducing earnings-per-share. The company is also confident of its growth as it is investing in a new factory. This is holding back profits this year but this investment should pay off in years to come with increased production.
There are certainly arguments for both approaches but in my mind the answer lies in the circumstances of the person asking the question. Dividend stocks are considered less risky which is beneficial if you are nearing retirement. However, if you’re looking to grow your pot, like me, then a higher-risk growth strategy could work.
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Robert Faulkner owns shares of Games Workshop. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.