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ETF Specialist

Dividend Income Versus Dividend Growth

Although the higher yields from high-payout-ratio stocks are enticing, companies that offer dividend growth are generally higher-quality.

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Just because a stock pays a dividend, it doesn't mean that its growth days are behind it. Take  Apple (AAPL) for example. The company paid its first dividend this past August but it is still projected to grow earnings by 21% per year during the next five years, more than double the 9% expected earnings growth rate for the S&P 500 Index, according to consensus estimates from Thomson Financial. Apple pays a quarterly dividend of about $2.65 per share. That equates to a dividend yield of about 2.0%, just shy of the 2.2% dividend yield on the S&P 500. Apple's dividend payout ratio, or the percentage of earnings paid out as dividends, is about 22%, based on the consensus forecast of $49.26 in per-share earnings for the next year. The conventional wisdom is that the higher the payout ratio, the lower the future earnings growth.

To see how the dividend payout can affect earnings growth, let's walk through an example. Say that a firm has $100 in capital and income of $10, for a return on capital of 10%. If it pays out 70% of earnings as a dividend, it would pay a $7 dividend and keep $3 as additional paid in capital. The next year, capital starts out at $103, and if we assume that the firm earns a 10% return on capital again, earnings would grow to $10.30 for 3% earnings growth. The more earnings the firm keeps, the greater the capital base and the faster earnings will grow. For example, if the payout ratio had been only 20%, the capital base would have grown to $108 and the 10% return on capital would result in earnings of $10.80, for 8% earnings growth. Of course, the higher the payout, the higher the current dividend yield is likely to be. Because utilities companies typically have steady capital needs with few growth opportunities, they tend to have high payout ratios and higher dividend yields, while tech firms have historically had low payout ratios as they often have many growth opportunities.

Michael Rawson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.