Dividend growth investing for beginners

Dividend growth investing for beginners

Osinko, utbytte, udbytte, utdelning or arður. Call it what you like, but dividends is a foolproof way to make consistent, predictable returns in the market. Companies can’t fake dividends, hence dividends are a strong signal of the company’s financial health given by the management. For decades, investors have leaned on dividends to help power their portfolios through both good and bad times in the market, and by adding dividend growth companies to your portfolio the dividends help to protect against inflation.

But first, what is a dividend? When a company earns a profit, it basically has two options:

Therefore, a dividend is a share of the after-tax profit of a company, distributed to its shareholders according to the number and class of shares held by them.

There are several advantages to dividend investing:

  • Maintaining purchasing power (Dividends have increased 4.2% since 1912, and inflation has increased 3.3%)
  • Able to take advantage of bear markets or market corrections, since you are earning a stabile stream of income from your portfolio
  • Dividends are less volatile than stock prices
  • Dividends is a strong signal about the financial health of a company
  • Motivational to receive cash flow from dividends

Dividend Growth Investing

The core to the dividend growth investing – strategy is to find businesses that will increase dividend payments over time. Dividend growth and reinvesting creates a virtuous cycle. Each dividend payment increases the amount of shares held, further increasing dividend payments, until you have a lean, mean dividend machine! When it comes to dividend growth rate, a stock with a long history of dividend payments is admirable and does make the stock more appealing. But, a more recent history of both dividend payments and increases is a better indicator of the stocks potential dividend payouts in the coming years.

Why should you focus on dividend growth stocks over regular dividend stocks? It is all about the characteristics of a dividend growth stock compared to a ordinary dividend stock. A high yielding dividend stock signals that the company is a mature, low growth stock with a high payout ratio, i.e. the company is operating in a declining industry. For dividend growth stocks on the other hand, the increasing dividend year over year is a strong sign that the company is operating in an industry with improving margins, growth or that the management executes on the company’s strategic goals. Check out these 20 Nordic Dividend Growth Stocks!

For a dividend growth stock the compounding effect of growing dividends does not come apparent the first years, but its’ power is easily observable after a couple of years when the snowball has gained momentum.

It sounds easy in theory, but to become a dividend growth investor you have to stay focused and not change your investment strategy if your portfolio underperform the general stock market in certain periods. The power of growing dividends are great, and even though Albert Einstein may not be credited for the following quote, I find it very descriptive of the DGI-strategy;

«Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t… pays it»

Over the last 40+ years, the annual compound return of stocks with growing dividends have outperformed dividend cutters on the S&P 500 by more than 4%. In simpler terms; if a stock you own reduces its dividend, it is paying you less over time instead of more. This is the opposite of what should happen. You must admit the business has lost its competitive advantage and reinvest the proceeds of the sale into a more stable business.

What characteristics should a dividend growth company exhibit?

Dividend investors should always want to know if;

  • A company’s dividends are affordable,
  • If there is a track record of consistent payments,
  • If the dividend is capable of growing. 

There are five core financial ratios to check first, and these are;

Dividend growth rate: The annualized percentage rate of dividend growth over a defined time period. You want to see stable dividend growth rates over a longer time period, but focus on the most recent history since this is a better indicator.

Dividend payout ratio: The amount of dividends paid out relative to total company income. For dividend growth stocks we want this metric to be as low as possible, since this increases the probability of a dividend increase.

Net debt to EBITDA: A high debt level for a dividend growth stock indicates that the past increases is funded by external debt obligations. The net debt to EBITDA ratio measures a company’s leverage and its ability to meet its debt obligations. A high net debt to EBITDA is a signal that the company’s operating profit cannot support the debt load and might indicate that future dividend increases is not probable. If the ratio is below 0, the company has more cash than debt.

Free Cash Flow to Equity: If a company does not generate free cash flow, it does not have funds to return to shareholders via dividends and share repurchases, nor does it have sustainable cash flow to use for acquisitions or debt repayments. 

Return On Invested Capital: Return on invested capital is similar to return on equity, but it measures a company’s return on equity and debt. The reason why you should focus on this metric rather than ROE is because it helps to adjust for differences in capital structures between firms. This way, it is easier to compare companies within the same industry.

Thanks to visualcapitalist.com for images

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