When evaluating a dividend stock, it’s useful to consider what kind of return you may receive from the stock.
City analysts use all kinds of complicated models and formulas when they calculate ‘intrinsic’ stock price values and expected returns, however, I believe the average dividend investor can go a long way with one simple formula.
A formula used by Neil Woodford
One theory that is popular among dividend growth investors is that in the long run it’s reasonable to expect the total return from a dividend stock to equal its dividend yield plus its dividend growth.
Total return = dividend yield + dividend growth
Woodford has endorsed this theory in the past, stating last year:
“In very simple terms, our total return expectation for a stock equals its dividend yield plus the anticipated rate of dividend growth.”
Dividend growth generates capital gains
It’s a formula that makes sense.
The return you receive from the dividend itself is easy to calculate because that’s cash in hand. For example, a 5p dividend from a 100p stock is a return of 5%.
However, the beauty of dividend growth stocks, is that over time, as the dividend payout rises, the share price should rise at roughly the same pace. I’ve explained this in detail in this article here.
This means that if a company is lifting its dividend payout by 6% per year, we can probably expect a long-term capital appreciation return of around 6% on top of the dividend yield, assuming other factors remain constant.
Adding the dividend yield of 5% and the dividend growth of 6% together, the expected return would be 11%.
FTSE 100 examples
Here’s a look at how the theory might apply to some popular FTSE 100 stocks:
Diageo (LON: DGE) (DGE.L) currently offers a yield of 2.6%. City analysts expect dividend growth of 6.8% and 6.3% over the next two years. Using the formula, we could expect total returns of 9.4% and 9.1%.
Legal & General Group (LON: LGEN) (LGEN.L) currently has a yield of 5.5%. City analysts expect dividend growth of 6.2% and 5.9% this year and next. This means we could expect total returns of 11.7% and 11.7%.
GlaxoSmithKline (LON: GSK) (GSK.L) currently sports a yield of 5.4%. But with analysts expecting dividend growth of just 0.0% and 0.6% over the next two years, the total return we can expect is 5.4% and 6.0%.
Of course, this total return formula is very simplistic. It ignores many factors such as fluctuating growth rates, earnings volatility and market sentiment (a key factor).
However, as a very basic concept, I believe it’s quite useful for assessing dividend stocks.
Disclosure: Edward Sheldon, CFA owns shares in Diageo, Legal & General Group and GlaxoSmithKline.
This article is provided for general information only and is not intended to be investment advice. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.