Dividend growth investing as a long-term strategy
Investment and Asset Management
There’s no one way to invest. Every investment strategy offers potential rewards and poses certain risks. The appropriate strategy or strategies for you depends on your personal goals, financial circumstances and risk tolerance. However, one strategy worth considering is dividend growth investing — or investing in companies with a solid record of paying regular, increasing dividends.
Although there are no guarantees, dividend-paying companies are often viewed as more stable and less volatile than other companies. Stock prices generally fluctuate, often as a result of factors unrelated to a company’s underlying performance. Dividend growth can be a better way to determine a company’s financial strength and future outlook.
Significant Contribution to Returns
When evaluating market returns, many investors focus exclusively on price appreciation. But historically, dividends have been a significant component of total returns.
A recent study by Hartford Funds examined the impact of dividends on the S&P 500 Index from 1960 through 2021. Over that period, the contribution of dividend income to total returns averaged 40%. The study also revealed that 84% of the S&P 500’s total return over the same period is attributable to “reinvested dividends and the power of compounding.” Hartford also reported that, going back to 1973, the stocks of companies that consistently grow their dividends exhibited higher returns and lower volatility than stocks of other companies.
Growth Vs. Yield
It’s important to understand the difference between dividend growth and dividend yield. Yield is the annual dividend per share as a percentage of a stock’s price per share. So, for example, if a company’s annual dividend is $5 per share and its stock price is $100, its dividend yield is 5%. Dividend growth, on the other hand, measures the percentage change in dividend payouts from one year to the next. If a company pays a dividend of $5 per share in year one and $5.50 in year two, dividend growth is 10%.
Dividend yield can be an important metric, but dividend growth usually is a better indicator of dividend trends over time. Suppose, in the above example, that the company’s stock price falls to $50 in year two and that its dividend per share drops to $3. In that case, the company’s dividend yield actually increases to 6%, but its dividend growth rate falls to –40%. Typically, companies that regularly increase dividends also regularly increase earnings.
Behind the Numbers
Healthy dividend growth can be a good indicator of a stock’s potential. But there are no guarantees that dividends won’t be cut or that stock prices won’t drop in the near future. Rather than relying on dividend growth statistics alone, it’s important to look behind the numbers to assess whether a company has a strong balance sheet, healthy cash flow and a management team that’s committed to maintaining dividend growth while reinvesting
in the company. According to Hartford, “Corporations that consistently grow their dividends have historically exhibited strong fundamentals, solid business plans, and a deep commitment to their shareholders.”
One useful metric in evaluating dividend growth potential is the payout ratio. This is the percentage of a company’s net income that’s paid out in the form of dividends. A company with a high payout ratio — one that’s earning barely enough to cover its dividend payouts — may be vulnerable to economic or competitive pressures down the road.
Think Long Term
Dividend growth investing isn’t for those looking for quick profits. It’s a long-term strategy that seeks to invest in stable companies with consistently increasing dividends and to take advantage of the power of compounding. And if you choose not to reinvest dividends, they can be an additional source of income. For this reason, many retirees invest in dividend-paying stocks.
Like any investment strategy, there are risks associated with dividend growth investing, including the risk of losing your original investment. But it can also be a valuable component of a well-balanced, diversified investment portfolio.