As an investor in the Australian stock market, what annual return is acceptable to you?
If you had simply invested in the All Ordinaries (INDEXASX: XAO) Index 10 years ago, which only tracks share price movements, you would have achieved an annual return of only 2.2%.
However, the All Ordinaries Accumulation Index, which includes the dividend component of return, would have delivered you a respectable 7% annual return.
The contribution of dividends to our total return on the ASX is easy to see, but is a dividend today worth the same as a dividend tomorrow?
For example, Commonwealth Bank of Australia (ASX: CBA) pays around 80% of its profits to shareholders which currently provides a yield of around 5.4%. The high payout ratio makes it hard to increase its future dividend if company profits don't grow, which could be possible considering the Australian Prudential Regulation Authority is placing new capital restrictions on our banks.
A 5.4% yield is a good return today, but the destructive power of inflation will make it less enticing in 5 or 10 years' time if the dividend payment doesn't increase. To make matters worse, the share price of stagnating companies often falls over time, increasing the risk of a poor return.
The answer
Investors need to find the high yielding stocks of tomorrow.
These are often younger companies with competitive advantages, operating in favourable industries that provide a solid growth runway for many years ahead. They should have low dividend payout ratios, reducing capital expenditure requirements and produce substantial free cash flows.
REA Group Limited (ASX: REA) is an Australian company of exceptional quality. Most readers will be familiar with its market-leading www.realestate.com.au website. However, its future growth will be powered by its international investments that include a 20% holding in iProperty Group Ltd (ASX: IPP), a 20% investment in US-based Move, Inc. and several European investments.
The business expands with minimal capital expenditure (currently around 6% of revenue), produces enormous amounts of free cash flow and pays out less than 50% of earnings in dividends.
REA Group's current yield of around 1.5% probably won't appeal to income-hungry investors today, but you need to consider future growth. In 2012, the dividend was 33 cents per share. In three short years, the dividend has more than doubled to 70 cents per share and should continue to grow quickly.
Finally, REA Group has delivered compounded annual returns of around 35% to investors over the past decade. The combination of capital growth combined with a growing dividend stream will power your future returns.
Foolish takeaway
For many investors, the dividend yield is an important consideration when selecting a company. For wise, long-term investors the current yield is certainly a consideration, but it is what that yield could be tomorrow that really matters.
