How You Can Enjoy a 25% Dividend Yield

Every now and then I write about "effective" dividend yields, such as in this piece about how my dividend yields are bigger than other people's. I occasionally hear from some readers who grumble that I'm wrong to pay any attention to such numbers, and that the current yield is all that matters.

I'll back up a bit, explain the situation, and argue against them.

For starters, let's review the dividend yield in general. To arrive at it, you simply take the amount a company pays out in dividends each year (usually in quarterly installments) and divide it by the company's current stock price. For example, Colgate-Palmolive (NYSE:CL) is paying $1.76 per year in dividends ($0.44 per quarter), and last week, it was trading around $59. Divide $1.76 by $59 and you get roughly 0.03, or a current dividend yield of around 3%.

So if you buy some shares of Colgate-Palmolive today, you'll enjoy a 3% dividend yield -- the company will essentially pay you 3% of your purchase price, per year.

Things change ...
The investing world isn't a static one, though. Over time, the price of the stock will change, going up and down from day to day. Over years, it likely will go up, if the company remains healthy and growing. The dividend, too, likely will increase. Healthy companies tend to hike their dividends relatively regularly. Over the past 20 years, for example, Colgate-Palmolive has averaged about 12% annual growth for its dividend.

Let's say that the dividend grows by 10%, per year, over the coming 20 years. And let's say also that the stock price grows at the same rate (which happens to be the average historic annual growth rate for the entire stock market, over many decades). Here's what you would see:

See anything interesting? That's right -- the dividend yield stayed the same! For anyone buying the stock in each of those years, they would receive 3% of their purchase price in dividends in that year.

Meet the effective yield
Here's the point I want to make, though. Remember that in our example, you bought your shares in 2009, at $59. You received $1.76 in that first year, your 3% yield. If you were still holding your shares in 2020, though, you'd be receiving $5.02 for the year in dividends. Divide that by your purchase price of $59 (instead of the then-price of $168.33), and you'll get an effective yield, a yield on cost, of 8.5% -- almost three times the then-current yield.

By 2029, after 20 years of holding the stock, your effective yield would be 20%. Five years later, it would be 32%! What you're looking at right now is the amazing power of dividend growth.

What to do
So go ahead and look for some significant dividend payers for your portfolio. In this market, they're much more plentiful than usual. Also, be sure to pay attention to the companies' dividend growth rates, because a rapidly growing dividend can give you a steep yield on cost in a number of years.

Here's a sample of some large-cap stocks with yields of at least 3% and dividend growth rates of at least 10% per year over the past five years:

Source: MSN Money.

That's not a rush-out-and-buy list, but instead a list for further study. Click over to our CAPS community of investors to learn more. (All of the above recently earned four or five stars in CAPS.)

A free, no-obligation trial of our Income Investor service will give you dozens of researched recommendations, many yielding 8% or more.