In the previous article, we discussed the strategy and ideas behind Dividend Growth Investing (DGI). Here we’ll go a little deeper into finding Dividend Growth Investment ideas and how to evaluate them starting with Dividend Champions, Contenders and Challengers.
Dividend Champions, Contenders and Challengers
A good source of Dividend Growth Investing ideas is the Dividend Champions, Contenders and Challengers list or the “Dividend CCC” list.
The list includes U.S. dividend companies with at least five consecutive years of dividend growth:
- Champions: increased dividends for the past 25+ consecutive years
- Contenders: increased dividends for the last 10-24 consecutive years
- Challengers: increased dividends for the previous 5-9 consecutive years
As of June 2019, there were 884 Champions, Contenders, or Challengers. And, a hat tip to George L. Smyth, who maintains this list and other valuable dividend investing resources on his site “The Drip Investing Resource Center.”
The Dividend CCC list contains widely recognized names across various industry sectors and less well-known companies, but industry stalwarts nonetheless, for further consideration. Some of the more well known names for example:
- Colgate-Palmolive Co. (CL) and Coca-Cola (KO) Consumer Staples
- ExxonMobil Corp. (XOM) and Chevron Corp. (CVX) Energy
- AT&T (T) Communications
- Wal-Mart Inc. (WMT) and Target Corp. (TGT) Consumer Discretionary
- Johnson & Johnson (JNJ) Health Care
Narrowing Down the List with the 10-step Guide to Stock Investments
This list of 884 candidates is an excellent starting point for a portfolio of Dividend Growth Investments. But, how do you choose which companies to actually buy?
That’s an excellent time to turn to the best investors in the world for guidance and apply the criteria they use to pick stock winners. In the 10-step Guide to Stock Investments here, we discuss the principles and methods used by the greatest investors in the world to select their winners.
Not All Dividends are the Same
Dividend stocks tend to outperform the overall market and non-dividend payers. But, not all dividend stocks are suitable investments all the time.
The members of the CCC list can find themselves out of favor at times and for various reasons. For example, is it a good company temporarily misunderstood by the market and selling at a bargain price? Or, is it facing insurmountable obstacles that will keep the price depressed and may even threaten the dividend?
A closer look at the company is the only way to sort out these questions.
Payout Ratio
The payout ratio shows the proportion of earnings paid out as dividends to shareholders. Typically expressed as a percentage of the company’s earnings. The payout ratio can also be expressed as dividends paid out as a proportion of cash flow. The payout ratio is also known as the dividend payout ratio (DPR). –Investopedia
DPR = total dividends/net income or,
DPR = dividend per share (DPS)/earnings per share (EPS)
The Dividend Payout Ratio is an important financial measurement used to determine if the company’s dividend payment is sustainable. If earnings per share are $2.50 and the company pays a dividend of $1.00 per share the Dividend Payout Ration would be 40% ($1.00/$2.50 = .40 x 100 = 40%).
A low payout ratio may mean a company is reinvesting its earnings into growing the business that may result in future dividend increases.
And, a high payout ratio indicates the company is already paying a large share of earnings out as dividends. This could be due to a decline in profits as a result of the normal business cycle or more challenging fundamental reasons.
Payout ratios are relative because some industries such as utilities or telecommunications tend to have higher Dividend Payout Ratios. Other sectors that are growing faster will typically pay out a lower percentage as they allocate more capital to growth.
The payout ratio should be judged against the industry average and the company’s own historical average and whether it is rising or falling.
The company needs to earn sufficient cash from which to pay the dividend. Income investors, like retirees in particular, rely on the dividend payment stream for income. Therefore, the market is very unforgiving on those companies that cut a retirees paycheck.
Earnings Growth
As we will see shortly, earnings growth propels the dividend and the stock price. The right Dividend Growth Investment candidate has a consistent track record of growing both earnings and dividends. And, it also needs to demonstrate it is on track to continue increasing earnings and dividends in the future.
This is where the 10-step Guide to Stock Investments is critical. The business must have a defensible position with sufficient returns to support future dividend growth.
Dividend Growth
As we saw in the previous article, companies that increase dividends consistently outperform those that do not. From 1972 and 2018, Dividend Growers and Initiators in the S&P 500 returned 9.6% and had higher returns than those that didn’t pay dividends.
If a company can consistently raise its dividend, it must also increase its cash flow and earnings to do that. So, consistent dividend growth helps to identify well-managed companies. Management committed to increasing the dividend show confidence in their company’s future earnings growth
Quality Makes a Difference
The long and short of it is quality business outperform over the long term. And, we can sort them out with these steps:
- Start with the Champions, Contender, and Challenger list.
- Use the 10-step Guide to Stock Investments and the wisdom of the best investors in the world.
- Review the candidates’ Dividend Payout Ratio, Earnings Growth, and, Dividend Growth record.
Sorting through the candidates with these three steps will start you on an excellent investing program and the path to financial freedom.
How to Estimate Returns on your Dividend Growth Investments
An excellent way to help you stay committed to this strategy is to rank the companies under consideration by potential future investment returns. It is also encouraging to see what the magic of compounding will do to your portfolio value over time.
The total return on Dividend Growth stocks comes from the current yield and growth of the dividend, and the future price appreciation of the stock.
It is safe to assume the share price will increase proportionately to the dividend growth over time provided the dividend growth is sustainable.
The investor’s total return will be the annual dividend yield plus the annual dividend growth rate. That is because the dividend growth rate will approximate the appreciation in the stock price. A convenient formula to estimate the total return of Dividend Growth stocks is:
Total return = % dividend yield + % dividend growth rate.
Let’s Work Through an Example
An investor is considering a company XYZ with a share price of $50 that pays a quarterly dividend of $0.45 or $1.80 per year. The current dividend yield is 3.6% ($1.80/$50 = .036 x 100 = 3.6%). Let’s also assume that it is also the average yield for this stock over time.
Management has set a goal of increasing the dividend at the historical dividend growth rate of 7% per year. Applying these to the formula the estimate of total annual return is:
Total return = 3.6% dividend yield + 7% dividend growth rate = 10.6% per year
Investors satisfied with a 3.6% dividend yield given the characteristics of the company in turn purchase more shares as the dividend increases 7% to $1.926 ($1.80 x 1.07 = $1.926).
The share price will also increases to $53.50/share to yield 3.6% after the dividend increase ($1.926/.036 = $53.50 share price). So, $1.926/$53.50 = .036 x 100 = 3.6%.
What we learned:
- The Dividend Champions, Contenders and Challengers are sources of Dividend Growth Investing ideas.
- Use the 10-step Guide to Stock Investments to further screen the ideas.
- Not all dividends are the same when measured by Payout Ratio, Earnings Growth, and Dividend Growth.
- Use the above three steps to start and excellent Dividend Growth Investing program.
- Estimate future returns using the Total Return formula.
In our next article, we discuss valuation and implementation of a Dividend Growth Investing plan.
Dividend Growth Investing – Part 1