Initial Yield versus Growth Rate

[benjamen]

The Chowder rule is an interesting idea to me (Initial Yield + Expected Growth Rate > 12%). I have been thinking about the relative importance a stocks Initial Yield versus its expected Growth Rate. I wanted to quantify their effects on the value you receive. To simplify things, I will assume dividends will actually smoothly increase exactly at the expected growth rate. I am also going to assume 1 yearly dividend to make my math quick (you can expand this method to semi-annual, quarterly, or monthly, but I am being lazy).

With the above assumptions, I believe we can use a modification of the equation for the present value of a growing annuity to give us a present value of future dividends.

http://www.financeformulas.net/Present_V...nuity.html

Generalized for our purpose:
PV = [(Initial Investment*Initial Yield)/(rate - Growth)] * {1-[(1+growth)/(1+rate)]^n}

Rate = the rate at which I am discounting future cash flows (usually a long term "risk free rate" such as 30 year treasury bond)
n = number of years of my time horizon
Note: make sure "rate" does not exactly = growth to avoid a nonsensical result

I played around with this for a while. Looking at the Chowder rule line where yield+growth=12%, it is interesting to see yield be more important as "rate" goes up and growth become more important as "n" goes up. Since I am interesting in long time horizons, I plugged in a large number (50) for "n" and varied my "rate" from 1% to 6% to find where I find the best returns. The sweet spot appears at a yield around 3-3.5% with a growth of 9-9.5%. Of course having a combined initial yield and growth above 12% is always better.

In the end, I found that going to far extreme with (low yield/high growth) or (high yield/low growth) is worse than (moderate yield/moderate growth).

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As a side note, you could use the equation for the present value of a growing perpetuity if you were assuming you never sell the stock, but only if "rate" is greater than Growth.
http://www.financeformulas.net/Present_V...tuity.html

[hendi_alex]

That is were I eventually settled. Of course it probably varies with stage of savings. Since we are now taking distributions, I'm shooting for a reasonable average current yield of around 5%, with some that yield a bit more and some a good bit less, but all of which have decent chance of moderate to good growth. I just don't have time or patience to wait on a 1.8% yield or a 2.5% yield to turn into something meaningful. The only time that I buy such low yielding issues, it is with the intention of a moderate term trade or for a covered call play, where the cash flow is juiced quite a bit from the call sell.