Imagine a stock that pays a $10 dividend and sells for $100. This is a rare stock that offers a jaw-dropping 10% yield. That’s nearly four times as much as the S&P 500 index at the moment. This is one of the best monthly dividend stocks 2017.
However, there’s a catch. This hypothetical stocks doesn’t grow. In fact, it will never grow. Decades will go by and the stock will experience neither capital appreciation nor dividend growth. Fast forward 30 years, and the stock will still pay $10 for every $100 you invested in it. However, now the investment is worth half as much and the dividends are worth half too. An average inflation rate of 2.5% has chewed up half your money and income in the span of three decades.
There was no dramatic drop in stock price or a sudden cut in profits and dividends. Business was just going on as usual. This was a stable and reliable investment, but it wasn’t a good one. McDonald’s (MCD) stock, for example, stayed range-bound for years. Inflation chews into the value of money over time. It is an invisible tax that every investor faces. Which is why, growth is essential.
Growth that outpaces inflation will preserve and expand wealth over time. Capital appreciation and dividend growth can make an investor richer without having to lift a finger. So long as the growth rate outpaces inflation.
Figuring out the future growth rate is also an essential part of traditional valuation techniques such as the Dividend Discount Model and Discounted Cash Flow methods. Estimating the growth rate is a crucial part of estimating the intrinsic value of a stock.
So, here’s a closer look at dividend growth and how you can estimate it while picking monthly dividend stocks 2017.
About Dividend Growth
Dividends are inseparably linked to profits. Which is why there are two factors that determine dividend growth – corporate policy and earnings growth. In other words, growing profits or a shift in management strategy could be the only way for a dividend to grow.
If sales and net earnings grow over time, it’s safe to assume dividends will keep up. After all, dividends are part of the net income after the company has retained some of it for reinvestment into the business. It is free cash flow. However, the corporate policy needs to align. If management feels pessimistic about the company’s future prospects, they may attempt to keep more of the capital within the organization.
They could keep more money retained on the books and continue paying the same amount of dividends for years. On the other hand, management could be feeling confident about the company’s prospects, in which case it could lift the dividend even though sales and profits haven’t grown. In fact, some companies borrow money to fuel dividend because they expect much higher profits in the future.
While corporate policy is hard to predict, it’s relatively easier to figure out if the company is likely to make more profits and expand in the near-future. Here are some of the techniques you can apply to figure out the rate of dividend growth over time.
One of the ways to estimate dividend growth is to start off with the top line in the income statement. By estimating sales and making assumptions about profit margins, you can make an educated guess about future dividend growth.
Take any monthly dividend stocks 2017 and see if there’s any indication of how much sales are likely to grow in the near future. Analyst reports and price targets are usually a good source for this data. Sometimes, company managers release a statement with ‘revenue guidance’. This guidance is usually an ambitious but realistic goal that the company’s leaders hope to cross over the years.
Alternatively, you could use public data and information about the new products the company is launching to figure out how much the top line will grow. For example, there’s a lot of commentary on how Apple’s new iPhoneX handset is cannibalizing iPhone 8 and 8 Plus sales. You can easily figure out how much Apple’s sales are likely to grow based on such reports.
Once you’ve done that, you can calculate whether the company will sustain its profit margins and payout policy for the foreseeable future. That should give you an indication of dividend growth rate.
Sustainable Growth Rate
Another clever way to estimate growth for a company is to use the ‘sustainable growth rate’ formula. This formula combines the amount of money the company reinvests into the business (retention rate) with the return on shareholder’s invested money (Return-on-equity). By multiplying the retention rate with the ROE you can figure out how much profits and dividends are likely to grow if the company simply sticks to running operations and policies as usual.
In the case of John & Johnson (JNJ), the return on equity is 22.8% while the retention rate is an average of 40%. That means the company earns nearly $23 for every $100 in shareholder equity and saves $40 for every $100 of net income. The sustainable growth rate should be 23% x 40% = 9.2%. By this estimate, J&J can expect to grow by nearly 9.2% every year. Dividends should grow at a similar pace.
Internal Growth Rate
Another, similar, way to figure out the growth rate of the company is to apply the internal growth rate measure. Unlike the sustainable growth rate measure, this one measure how much the whole enterprise can grow without having to resort to external funds.
Basically, the internal growth rate shows how much a company can grow if it never borrows or issues new shares to raise funds. The formula relies on the book value of assets instead of equity.
Historical Growth Rate
Finally, the easiest way to calculate future growth is to simply look back. If a company has a history of growing dividends at a certain pace for an extended amount of time, guessing its future growth becomes a little easier.
However, past performance is no guarantee of future returns. The dividends and earnings in the future could be a lot harder to create. Changing markets, fundamentals, and unseen economic conditions could all have an impact on the company’s actual growth rate.
The only way to apply the historic growth rate appropriately is to take it with a grain of salt and only apply the measure to stable companies with predictable business models. Software, for example, may not be as stable as selling toothpaste. With a little discretion, you can apply this measure to gain some insight into the company’s potential.
Risks To Dividends
Dividends are under constant threat. Intense competition, too much debt, failed projects, or a sudden recession could have a direct impact on the company’s profits. Dividend cuts and adjustments could follow soon after such a disaster.
A key factor in figuring out dividend growth is to check for risks and uncertainties. Run a dividend health check on the monthly dividend stocks 2017 to see if the dividends are safe. If there’s any sign the company cannot sustain the dividend, any guess of future growth is fundamentally flawed.
Trying to find the best monthly dividend stocks 2017 isn’t just about safety and yield. Some of the best dividend payers could be operating in contracting markets with declining profits. This makes the dividend unsustainable.
For income-seeking investors who rely on their dividends to meet monthly expenses, growth is a crucial factor. Not only does growth help investors beat the wealth-eroding effects of inflation, but it can also help investors value their holdings appropriately.
Over time, dividend growth and capital appreciation becomes the most crucial factor in applying an investment strategy. Figuring out the growth rate takes a little research and a lot of educated guesswork. You can extend the current dividend growth rate into the future or guess future sales. You can also apply the sustainable or internal growth rate formulas to figure out future growth.
Any method you apply, remember the future is uncertain. Growth rates will rarely match up to your expectations or current calculations. There are simply too many changing factors that affect profitability and dividend policy. Do your research, make conservative estimates, check for financial strength, and invest with a margin of safety.