Why a smaller dividend yield can lead to more passive income

Passive income is one of the greatest advantages of investing in (ASX) shares. I believe there are valid reasons to say that a lower dividend yield could produce better income in the long run than a higher yield idea.

When I think of some of the most popular businesses for passive income, names like Commonwealth Bank of Australia (ASX: CBA), BHP Group Ltd (ASX: BHP) and Woodside Energy Group Ltd (ASX: WDS) come to mind.

Owning a business like that could deliver a solid yield upfront, but may not be the best option in the long term.

Why a lower dividend yield doesn’t mean an inferior investment

If someone invested $1,000 in a dividend-paying business with a 5% dividend yield, it would unlock $50 of annual passive income. A 2% dividend yield would only mean $20 of annual passive income.

For passive income investors, the 5% yield option looks more compelling.

But it’s important to remember why some businesses have lower or higher dividend yields than others.

The dividend yield is influenced by two different factors: the dividend payout ratio and the price/earnings (P/E) ratio.

A high dividend payout ratio and low P/E ratio will certainly produce a high dividend yield.  But that also means the business isn’t priced for much growth and isn’t retaining much profit each year to support its earnings growth.

A lower dividend yield likely means the market expects more growth over time and has a lower dividend payout ratio – it’s retaining more earnings to reinvest in the business to support profit performance in the coming years.

Dividend growth can win

We can’t know for sure what the dividend payouts will be in the coming years, but it’d make things easy if we knew!

If a fast-growing business increases its payout by 15% per year, a 2% dividend yield could grow much larger. It doubles to around 4% in five years and more than 8% in ten years.

If a business with a 5% dividend yield grows its payout at 2% per year, it reaches 5.5% after 5 years and 6.1% after 10 years.

After ten years, that $1,000 investment would pay around $80 per year from the business with a lower yield and around $60 from the higher dividend yield.

Of course, there are no precise examples of businesses delivering those levels of growth. But, companies like Pro Medicus Ltd (ASX: PME), TechnologyOne Ltd (ASX: TNE) and Altium have been names that have delivered significant dividend growth.

ASX shares that I’d back for long-term dividend growth today are TechnologyOne, Lovisa Holdings Ltd (ASX: LOV), Guzman Y Gomez Ltd (ASX: GYG) and Breville Group Ltd (ASX: BRG), among other names.

The post Why a smaller dividend yield can lead to more passive income appeared first on The Motley Fool Australia.

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Motley Fool contributor Tristan Harrison has positions in Breville Group, Guzman Y Gomez, Pro Medicus, and Technology One. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has positions in and has recommended Lovisa and Technology One. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has recommended Pro Medicus. The Motley Fool Australia has recommended BHP Group, Lovisa, Pro Medicus, and Technology One. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.