One of the best things about investing in stocks is that depending on the shares your own you can get a check delivered to your home every couple of months. While initially this check will start out small over the years it may grow to amounts that can really change your lifestyle. Dividend growth investing is a strategy that focuses on dividends and their potential growth over the course of many years. In many ways it is tied to value investing in that the fundamentals of the company are very important and that in the end what will determine how the end results of a particular investment depend on the company’s performance and not on what the stock market does.
Here are some of the fundamentals of dividend growth investing to get you on the right track:
The price that you pay for and investment will greatly affect an investments performance regardless of the time you hold an investment. Benjamin Graham who is considered the father of value investing always responded when asked about securities by asking the price of the security and the desired holding time. Many dividend growth investors buy at the current market price and forget about the importance of the initial price paid for a security. The reason why this approach is flawed is simple.
Here is an example:
Company ABCD’s (imaginary company) shares are trading at $100 per share and yield 2.50% for an annual dividend of $2.50 on October 2, 2001. Two weeks later the shares fall to $90 per share. Now let’s look at the effects on the yield. If the shares are trading at $90 and are paying the same dividend of $2.50 per year the dividend yield climbs to 2.77%. While this looks small at first consider that the stock will be held for many years and that dividend growth starts from one point and that is the initial dividend yield. Imagine that our imaginary company increased the dividend by 10%. An investor that bought shares at $100 would be getting $2.75 the same as a person that bought them at $90. For the $100 a share investor the stock now yields 2.75% but for the $90 a share investor the stock yields 3.05% over the principal invested.
Still not convinced? Here is a more interesting example:
To make things easier we will be using our imaginary companies ABCD’s shares again. Let’s say that you have $10,000 to invest. If you invest all of your money when shares are trading at $100 you would be able to buy 100 shares and receive a dividend of $250 the first year. If the company hikes the dividend by 10% you would get $275 the next year. Now, if you had invested the same amount of money when the shares were trading at $90 per share you would have been able to buy 111 stocks for $9990. Since a lower price lets you buy more shares for the same or almost the same money and the yield per share is higher. The first year this investment would have sent $277.50 to your a few dollars more than what buying at $100 per share would send the second year. The next year if the company hikes the dividend 10% you would get $305.25 which is a difference of $30.25 for the $90 per share investment.
Dividend growth rate
The dividend growth rate is the rate at witch a company has been increasing its dividend over the years. Many companies do not increase the dividends at the same rate year over year but it is still useful to look at the history of their distributions to determine if their average growth rate is what you are looking for. Look for consistency in dividend increases. Some firms have been increasing their dividends for more than thirty years which says a lot. If you are really looking for income growth, stick with companies that increase payments at least 10% per year. There are many companies that fit this criteria so don’t worry the search is very easy to do. There are even some that have been increasing their payments by more than 17% for years.
Dividend payout ratio
Many companies that are considered dividend growth stocks have low payout ratios in the 15% - 40% range. The lower the payout ratio the better, because it means that the company has room to boost payments without sacrificing growth. A company that has a high payout ratio has less room to increase dividends and at the same time less available money to buy back shares and expand operations. Don’t feel discouraged by a company with a payout ratio of more than 40%. Companies like Johnson & Johnson and McDonalds have been increasing dividends for many years and have payout ratios ranging from 45% to 55% yet, they have managed to grow net income and buy back shares at the same time.
Earnings per share
Increasing earnings per share means more profits per stock owned therefore more money that can be sent home in the form of dividends or be used to buy back shares. There are many ways that a company can increase a stock’s earnings per share like increasing inventory turn over, increasing profit margins or buying back shares. The best companies out there increase profits and buy back shares and for this reasons they have long streaks of dividend hikes.
How to accelerate income growth
Accelerating income growth is easy. Enroll your shares in a dividend reinvestment program that has a low or no cost at all and watch dividends grow faster and faster with every payment received. Many online brokerage houses like Td Ameritrade allow your shares to be enrolled in a dividend reinvestment program for free. Keep in mind that even if they are being reinvested you sill need to pay taxes.
These are some basic concepts that you can use to start using this philosophy in your investing journey. There are many other things like free cash flow, debt levels and growth expectations that are important to consider. Remember that investing carries risk and that this is a long term strategy and that it takes time for those little payments to grow huge.
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