With increasing life spans and the rising cost of living, many investors are looking to draw more income out of their stock portfolios, even before they retire. The right strategy for an investor close to or in retirement will be different than a strategy for younger investors or those with less lifestyle overhead and more ability to take on risk.
Growth investing involves looking for stocks from companies that show promise of fast growth or achieving significant scale over time. This strategy’s success rests on the price of the stock itself increasing, versus relying on dividends for boosting portfolio returns.
In contrast, the dividend growth investment strategy’s goal is to increase dividend income from a steady flow of dividends over time. Active investors often take a blended approach, depending upon market conditions. Because dividend paying companies distribute a portion of their profits to shareholders, most fall into the value category.
One thing to keep in mind is that a dividend growth strategy requires long-term investments. For investors looking for short-term growth, dividend growth stocks may not be the right fit. Let’s look at the dividend growth investing strategy in more detail.
What Is a Dividend Growth Investing Strategy?
The foundation for a dividend growth investing strategy is owning shares in companies with a history of paying regular and increasing dividends. (Tweet text) Stocks that are good candidates for this dividend income strategy are generally stable with a positive future outlook, given past performance. Historically, dividend stocks show low volatility while still outperforming the S&P 500.
Dividends are also a major source of long-term returns. For the years 1930 through 2018, dividends accounted for 43% of total S&P returns.
Dividend’s Contribution to Total Returns by Decade
During times of market volatility, a quality dividend growth stock can provide a rising income which creates a compound effect over time when reinvested into more shares.
Like other portfolio income boosting strategies like selling covered calls, investors turn to a dividend growth strategy to diversify and also as a hedge against inflation or market downturns.
Dividend Yield and Dividend Growth Rate
Two important ratios for a dividend growth strategy are dividend growth rate and dividend yield. The growth rate measures a company’s dividend trends over time. The dividend yield is a snapshot indicator – how much a stock is paying out now in dividends compared to its share price. Below we look at each ratio, along with a few others.
What is dividend yield: the annualized dividend as a percentage of stock price.
How to use dividend yield: The dividend yield compared between two companies tells you which will pay more per dollar invested.
How to calculate dividend yield: To calculate dividend yield, simply divide the annual dividend by the price of the stock.
Annual dividend yield = [annual dividends per share/share price]
So for a share price of $60.00, which offered a dividend of $3.25 per share last year, the annual dividend yield would be 5.4%
High Yield Isn’t Everything
On the surface, buying stocks with the highest dividend yield may seem like the most straightforward strategy. In reality, an unusually high dividend yield could be a warning sign.
It turns out that high yields can be the result of a risk of the dividend being cut, leading to a fall in the stock price. This is called a dividend yield trap.
Here are some tips to avoid a yield trap. You can also use these tips to gauge long-term dividend growth, which is likely more profitable in the long run than investing only based on high yield.
- Take the long view for a moment. Is the company at risk from strong competition or weak demand? Is the industry vulnerable to disruption?
- Get a sense of a company’s dividend history using annual payments and dividend increases.
- Compare yields across companies in the same sector. If a company’s yield stands out as much higher than other players in the space, that may be a sign of trouble.
- To gauge a dividend’s sustainability, check earnings per share and payout ratios.
- Check out the balance sheet and review debt, cash, and other assets and liabilities.
Dividend Growth Rate
What is a dividend growth rate: The dividend growth rate calculates dividend growth over a period of time.
How to Use dividend growth rate: A robust dividend growth rate suggests an increase in dividend payouts over time. This in turn may signal stability, because the underlying condition enabling the dividend growth is consistent revenue growth.
How to calculate dividend growth rate: Divide the stock’s annual dividend by the previous year’s annual dividend, and subtract 1. For instance, let’s say a company’s current annual dividend is $3.50 per share, but last year the company offered $3.25 per share. The dividend growth rate would be 7.7%.
Dividend growth rate = [Current annual dividend / previous year’s annual dividend] – 1
To find the dividend growth rate over a range of years, average the individual dividend growth rate change for each year in question. At TrackYourDividends, we focus on the 5 year dividend growth rate.
Cash Dividend Payout Ratio
What is the cash dividend payout ratio: this ratio is the dividend as a percentage of a company’s free cash flow – operating cash flows minus capital expenditures. It matters because non-cash expenses can cause variations in earnings and free cash flow over time. Those variations may make the company’s payout ratio misleading.
How to use cash dividend payout ratio: Investors can use the cash dividend payout ratio, along with the simple payout ratio, to better understand a dividend’s sustainability.
How to calculate cash dividend payout ratio:
[Cash dividend payout ratio] = common stock dividends / (cash flow – capital expenditures – preferred dividends)
What is the total return: The increase in stock price (known as capital gains) plus dividends paid.
How to use total return: To calculate the overall return on a stock purchase.
How to calculate total return:
Total return = [price increase (or loss) + dividend] / original share price
For example, if you pay $10 for a stock that increases in value by $1 and pays a $0.50 dividend, then that $1.50 you’ve gained is equivalent to a 15% total return.
Earnings Per Share (EPS)
What is earnings per share: a company’s net profit divided by the number of common shares it has outstanding.
How to use EPS: A metric for estimating corporate value.
Companies with the best dividend stocks are those that have been able to consistently increase earnings per share over time and thus raise their dividend.
How to calculate EPS:
EPS = [net profit / # of common shares outstanding]
What is the P/E ratio: the stock price divided by the company’s earnings per share for a designated period like the past 12 months.
How to use the P/E ratio: The P/E ratio can be used along with dividend yield to determine if a dividend stock is fairly valued.
How to calculate the P/E ratio:
P/E ratio = [share price/earnings per share]
How to Find Stocks for Your Dividend Growth Strategy
What kind of companies do dividend growth investors look for? Here are some characteristics:
- Consistent dividend payment growth over time.
- A dividend growth rate that is greater than, or at least equal to, the rate of inflation
- Companies that pay dividends from current profits, not accumulated capital or debt. This makes sense intuitively
- Diversification in companies in a variety of industries, limiting the effect of a decline in one sector.
Researching stocks and companies can take a lot of time. One place for new investors to start is with Historically Great Dividend Companies:
Dividend Kings Companies that have increased their stock dividends for more than 50 consecutive years. Dividend Aristocrats are companies with more than 25 years of consecutive dividend increases. Keep in mind, though, that even though a company has been paying dividends for decades, it can be easy to assume they will for a long time to come. In reality, nothing is guaranteed so be sure to keep on top of your research for all your stocks.
Another useful tool that saves time in comparing stocks and company information is a dividend stock screener that helps you evaluate dividend stocks based on your individual criteria.
How to Optimize Your Dividend Growth Investing Strategy
Once you have your dividend portfolio set up and start collecting earnings, how will you reinvest them? Active investors may choose to reinvest their dividends manually. Others use a dividend reinvesting plan, also called a DRIP, and track their progress with a dividend reinvestment calculator.
DRIPs reinvest every dividend you earn back into shares of that company, without fees, and This is an auto-pilot bonus for your strategy and can lead to compound returns over time.
What Are the Tax Implications for Dividend Earnings?
An important part of any portfolio strategy is tax planning. Most dividend stocks pay “qualified” dividends, which are taxed at a rate of 0% to 20%. Note that those tax rates are much lower than the ordinary income tax rates of 10% to 37% or more.
Be aware that some dividends are classified as “ordinary” or non-qualified dividends and are taxed at your marginal tax rate. Several kinds of stocks structured to pay high dividend yields may have higher tax obligations because of their corporate structures. Master limited partnerships, or MLPs, and real estate investment trusts, or REITs are two common examples.
The Bottom Line
A dividend growth strategy can be an effective income-boosting strategy for the right investor. As you can see, there are many moving pieces. Setting up and maintaining your portfolio takes a lot of research and work. TrackYourDividends is a free dividend tracker app with a full suite of dividend tools to help you manage your dividend portfolio. Get started for free today.