Yield growth’s effect on returns
Given a market where there is a liquid market for an asset at fixed multiples of yield, how does growth of yield affect return? The answer is simple. And powerful.
Let me rephrase the question in less academic terms. If you bought a share with a dividend of 6%, but the dividend is growing at 4% (next year dividend would be 6.24% of original purchase price), and there was always someone willing to buy the shares at the same ratio as what you bought it at (100/6 or 1/6% or 16.67) what would the effective return be? This question applies to property and rents too.
First, let me explain why I was looking for the answer. Some assets, like dividend yielding shares and property, have yields that are variable, while other assets like bonds & deposits, have yields that are fixed. So, what I wanted to understand was how to compare a share yielding 6% dividend growing at 4% per year with a bond that yields 8% a year.
The answer is surprising simple. The effective return in such a scenario is yield + rate of growth of yield. i.e. in the above case the effective return is 10%.
Since the dividend yield grew by 4%, and we assumed that there is a steady market for the assets at the same fixed ratio as you bought, a year later the share should sell at 1.04 times the original price. So, your effective return is 6% in yield by 4% in unrealised capital gains.
You can simulate this in excel quite easily, if you are careful about the details. Here is my version:
Two slightly non-intuitive notes on the excel:
- the dividends are assumed to earn the same rate of return as hurdle rate (this is consistent with the assumption we made that there exists a liquid market for the asset at fixed multiples of the yield — you could just buy the same asset at the same ratio and end up earning the return on it, ergo compounding effect)
- the P/E of 17.33 is arrived at despite the price being 100 and yield being 6% because the 6% is the dividend of last year, so you have to discount it by the rate of growth (i.e. 4%) to arrive at the right yield for last year based on this years price. So P/E is 100/(6/1.04) or 17.33
As you can see the total return of 10% matches the standard compound interest result @ 10%.
This model assumes that there is a market for an asset at 17.33 times last year’s yield. This is obviously not true in reality. That ratio often go up (making the asset costlier) or down (making the asset cheaper). However, if you feel that the ratio you are buying at matches your personal expectation of returns, and that that ratio is not abnormally high for that asset based on past data i.e. for most of future, the expectation is that the ratio will mostly stay around that mean with a small standard deviation; then you have a good asset at hand to buy.
So, now that this is established, what you really want is to look for assets whose yield + growth-in-yield matches your expected returns!
(ps: To answer the question I posed earlier, always choose a share yielding 6% dividend growing at 4% per year over a bond that yields 8% a year.)
