You may have heard about dividend growth investing. It’s the concept of buying stocks that not only have great dividend yields, but are likely to actually increase the amount of dividends paid over time.
Dividend growth investing could be the best way to create a rock-solid income generating portfolio. It’s a clever way to create a passive income stream that simply compounds and expands over time. Here’s what you need to know:
It helps to think of companies as compounding machines. Companies earn a return on the money they invest into the business. If the business is successful, the amount of profits grow over time. As the company makes more in profits, it’s likely the dividends paid out to shareholders will also grow in tandem. This means the wealth of the company compounds, which allows your portfolio to grow exponentially.
Growth investors seek out dividends on the basis of their potential for growth. While most dividend investors will simply focus on the dividend yield and sustainability, dividend growth investing goes one step beyond and considers future potential. The theory is that a good business is able to keep paying a dividend that grows faster than the rate of inflation. In other words, a high dividend yield is meaningless if the same amount of money is paid out year after year and inflation slowly erodes the value of the cash.
Of course, this strategy for dividend growth investing involves a lot more effort. Not only is the investor supposed to look for high yield and check the company’s financial health, but she must also attempt to estimate how well the company is likely to perform in the future.
It’s important to realize the link between dividends and profits. Dividends stem from free cash flow, which means they are paid out after the company has earned enough of money to reinvest in the business and still has cash leftover. This leftover cash is the key to understanding the potential for dividends. It provides headroom for the dividends to grow and be sustained.
Here are some important terms you’ll need to understand before we delve into the math behind dividend growth:
Dividend Yield: A great way to understand dividends is to compare them to rents. If you bought a house for $100 and the annual rent you earned was $2, your rental yield would be 2%. Similarly, if you buy a company’s stock for the same price and earn the same amount in dividends, the yield is 2%. Yield is essentially the amount of money you get for every dollar invested. You have to ensure that the yield on a stock is more than what you can earn risk-free (in a US Treasury bond) and the rate of inflation.
Dividend Growth Rate: The rate at which dividends grow is essential for dividend growth investing. A good way to estimate how much the growth rate will be is to see how much it has been. If the dividends over the past thirty years have grown at 10% annually, a dividend of $1 has grown to over $17 today. You can expect similar levels of growth over the long-term, provided the business performs just as well going forward.
Payout Ratio: The payout ratio is the portion of earnings paid out in dividends. For example, if your company earned $1 per share and decided to pay out $0.50 in dividends, the payou ratio would be 50%.
Dividend Growth Maths
Let’s assume we have a company that earns $10 per share and each share is priced at $100. This means the price-to-earnings ratio is 10x. The company regularly pays out 30% of earnings as dividends. The management assumes the earnings will double in 7.2 years. That means earnings will grow at 10% every year for the next decade.
Now, if you assume the payout ratio, P/E ratio and growth rate will all be maintained as expected, the company will earn $20 per share after ten years. At a PE ratio of 10x, the price per share should be $200. The dividends, meanwhile, have also grown to $6 per share.
As the company earns more your dividend increase and so does the capital appreciation. The stock price and dividends are linked in this way. But the real magic happens when you use the dividends to reinvest in the stock.
The Power of Reinvestment
A number of companies offer dividend reinvestment plans or DRIPs. These plans allow you to apply the dividends to increase the amount of shares you own. Over time the amount of a company owned increases exponentially, leading to better capital appreciation and high wealth.
Here’s how it works. Let’s go back to the stock we mentioned earlier. If you invested $1000 in a stock that yields 3% in dividends and is expected to increase earnings (and dividends) by 10% every year, after 20 years, here’s what your results will look like:
After 20 Years (No reinvestment)
After two decades of sustained growth your initial $1,000 investment will grow to nearly $6,727. Every year you will receive $202 in dividends. The total return will be over 572%, while you’ve earned and enjoyed $1718 that you received in dividends over the 20 years.
That might seem impressive, but let’s say you reinvested the dividends instead of spending them. Every year you received a dividend you went ahead and bought more stocks of the same company and never considered using the money for consumption. Would that small change make any difference? Here’s what your performance would have been under a DRIP (assuming no taxes):
20 year returns (Dividends reinvested annually)
Your return is 1052% and the amount of wealth is $11,523. Also, because you now own more stocks, the amount you receive every year in dividends is a whopping 70% more.
Simply buy putting the money back into the stock and allowing it to compound over twenty years, the wealth at the end of the period was remarkably larger. Studies have found that dividend reinvesting has actually been the best way to outperform the markets over time. Since the S&P 500 started eighty years ago, dividend reinvesting has generated a return 8 times higher than simply holding the index and spending the dividends. 44% of the total return of the S&P 500 since the 1920’s has been due to dividends.
The Potential for Growth
Now that you understand the need for dividend growth, it’s time to note the factors that lead to growth. A company that is likely to grow its dividends is one that has a track record of growing dividends. Check the Morningstar Dividend Growth Index or Dividend Aristocrats Index for a list of companies that have been consistently growing dividends for decades.
Pay attention the industry’s prospects and the potential for higher profits. If the company performs well and the economics improve over time, you can expect dividends to grow as well.
Make sure the companies you pick are not borrowing aggressively to fuel growth or investing in high risk projects that could make the stocks more volatile. Pay close attention to the cash hoard and free cash flows at the companies. Check the dividend coverage ratio to see if the company has enough headroom to grow or sustain dividends.
Dividend growth investing is certainly a clever way to apply compound interest and grow your wealth over time. You will need to dig deeper than most income-seeking investors, but if you can appropriately estimate the dividend growth, you can invest in some excellent stocks for the long term. As the company lives up to expectations and expands its earning power, your wealth will grow automatically.