When it comes to dividend stocks, few are more iconic than Coca-Cola (KO -0.75%). The stock is both a high-yield investment and a Dividend King (we'll unpack what these terms mean in a moment). Investors looking to buy top dividend stocks typically take a peek at Coca-Cola.
Starbucks (SBUX -4.44%) is neither a high-yield dividend payer or a Dividend King -- it's not even a Dividend Aristocrat. And yet I believe it's a better dividend stock for long-term investors.
Overlooked dividend growth
Many experienced investors understand you can't time the market. Take this crazy year as an example. Who would have thought stocks would be up while we are in the middle of a global pandemic and a recession? The S&P 500 is not only up over 50% from March lows, it's also up around 5% year to date. If you attempted to time the tops and bottoms of this volatile year (and some undoubtedly tried), you probably lost some money.
Long-term investing is a better alternative to market timing. Yet it requires envisioning where things are going, not fixating on where things are or have been. This makes intuitive sense, but sadly these principles aren't often applied when choosing dividend stocks. Investors simply look at the most appealing backward-looking metrics right now.
I'm mainly talking about investors' infatuation for high-yield dividend stocks. Dividends are measured in relation to the cost of buying the stock. If you buy a stock priced at $100 a share that pays $3 per share per year in dividends, its dividend yield is 3%. Any stock paying above 2% is typically considered a high yield. Coca-Cola stock falls into this high-yield category, and it's one of the many reasons investors love it. Starbucks is considered low yield, so it's often overlooked as a dividend investment.
Here's the one chart that will help long-term investors see these two dividend payers in a new light:
Five years ago, Coca-Cola's dividend yield was about what it is today. Starbucks' dividend yield was about 1%. Yet over these years, Starbucks has crushed Coca-Cola with dividend growth. This has big implications the longer you hold a dividend stock.
Growth can beat high yield in the long run
When buying a stock for its dividend, it's important for payouts to occur regularly. But sometimes unexpected things happen (like the coronavirus pandemic), and companies pause their dividends. But other companies keep an uninterrupted streak going for years and even increase the dividend at least once per year. If an S&P 500 company does this for 25 consecutive years, it's known as a Dividend Aristocrat.
Give Coca-Cola its due: It has one of the greatest dividend track records around. Not only is Coca-Cola a Dividend Aristocrat, but it's also a Dividend King, having paid and raised its dividend for at least 50 consecutive years. Only 10 S&P 500 companies currently fit this description, showing just how elite Coca-Cola is for dividend reliability.
There's only one problem. Coca-Cola's dividend raises have shrunk in recent years. Earlier this year, the company raised its quarterly dividend payout from $0.40 per share to $0.41 per share, a 2.5% raise. In contrast, Starbucks just announced a 10% raise to its dividend.
Let's assume equal investments in two different dividend stocks and that the stock prices for each remain relatively comparable (i.e., they grow or shrink at the same rate). One dividend yields 3% and is growing at 2.5% per year. The other dividend yields 2% but is growing at a 10% rate. After six years, the 2% yield stock will be paying out more than the 3% yield stock, because of its faster growth rate. After 12 years, the 2% yield stock will have returned more in total even when taking into account reinvested dividends.
In all fairness, other factors like significant changes to the stock price or company earnings, any potential stock buyback efforts, etc., can affect the outcome of these calculations. But the point is: Long-term investors (i.e., those in it for decades) shouldn't overlook the power of dividend growth. Starbucks offers it, and that's why I prefer it as a dividend stock.
We're talking about a very long-term investing horizon -- too long perhaps for some. But I personally have decades before retirement. Not all investors do; your time frame should be taken into consideration when choosing.
But there might be further objections to my choice of Starbucks. It may be unrealistic to project consistent 10% annual dividend growth over more than a decade. That's true, but to be fair, neither company is guaranteed to grow its dividend at the current rate. And Starbucks has more room for growth as it hasn't been paying out a dividend as long as Coca-Cola.
It also pays out less of its earnings in dividends (by percentage) than Coca-Cola does. This is known as a payout ratio. Therefore, Starbucks has more free cash available to put toward future raises. Furthermore, it has stronger opportunities to organically grow earnings over the next decade, increasing the odds of higher payouts in the future.