As dividend growth investors know, earning passive income isn’t just about how much a stock pays out today. It’s about what future distributions look like and how durable they’re going to be.
Right now, shares in Diageo (LSE:DGE) come with a 2.77% dividend yield. With interest rates at 5.25%, that’s not immediately attractive, but the company has a strong record of growth to consider.
Dividends
If I invested £10,000 in Diageo shares today, I’d hope to receive £277 in dividends within the first 12 months. There’s no guarantee – the company isn’t obliged to pay out anything – but this seems likely.
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Compared to other opportunities available at the moment, that doesn’t seem hugely attractive. Government bonds, for example, seem to offer much higher returns.
Ten-year UK government bonds currently come with a 3.94% coupon, meaning a £10,000 investment could be expected to return £394 in the first year. And that figure’s £442 for a 30-year bond.
Given this, it might be hard to see why anyone would want to invest in Diageo shares over a bond. But there’s an important difference – the drinks manufacturer is likely to pay out more in the future.
History
Over the last 20 years, Diageo has an impressive history of increasing its dividend per share. Each year without fail, shareholder distributions have been higher than the year before.
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The amount of the increase hasn’t always been the same. But the Great Financial Crisis, Brexit, and the Covid-19 pandemic haven’t derailed the company’s progress.
I think that makes it hard to see what might. Diageo’s track record isn’t a guarantee of what will happen in the future, but betting against future increases looks unwise to me.
On average, the company’s dividend has increased by around 5% a year over the last decade. The question is whether the stock will be a better investment than a government bond if this keeps up.
Outlook
The short answer is that it probably depends whether or not Diageo’s current growth rate continues. A £10,000 investment today will distribute £3,484 in dividends over the next decade.
A 10-year gilt with a 3.94% yield will return £3,940. So unless the rate of its growth increases, the bond will pay out more cash to investors over the next decade.
The required rate to close the gap would be just under 8%. And this looks somewhat optimistic to me given the nature of Diageo’s business.
With a 30-year time horizon, things look different. A 5% annual dividend growth would lead to £18,403 from Diageo shares, compared to £13,620 from a bond with a 4.42% yield.
Passive income
There are always risks with investing, but I think Diageo’s business is more predictable than most. I’m expecting growth to be steady, but not spectacular.
With 5% annual growth, a £10,000 investment in Diageo shares could pay £1,166 in passive income after 30 years. And this looks attractive relative to a bond.
I’d therefore consider the stock for my portfolio, but only over a long period of time. Over 10 years, I think there are better opportunities available.
