Dividend stocks have a place in every investor’s portfolio. However, savvy investors know that the secret to success in dividend investing is to identify companies that have a history of increasing their dividend yield over time. Companies that pay dividends are typically mature companies in what are considered defensive stocks (utilities, consumer staples, etc.). These stocks do not generate the same capital growth as high growth stocks so they offer a dividend to help reward shareholders. The best of the best of these stocks are the dividend princes, aristocrats, and kings that have a 10, 25, and 50-year history of increasing their dividend. Dividend investors that do not need the income right away can also take advantage of re-investing dividends as a strategy to help maximize their total return. And for investors who are more comfortable with fund investing, there are a variety of mutual funds and ETFs that are specific to dividend stocks.
Introduction
Income-oriented investors love dividend stocks. These investors love dividend stocks that consistently increase their dividend. As dividend yields go up, it typically causes share prices to increase. This is a win-win for investors as they generate regular dividend income while seeing the value of their shares increase. In this article, we'll take a look at how investors can look for stocks that are increasing their dividends and how to maximize their gain from those investments.
What is a dividend?
A dividend is a monetary payment made to shareholders that comes out of a company’s profit. A dividend is declared and usually pays out quarterly. However, some companies pay a monthly dividend. Still, others pay a single, annual dividend. Investors that are looking for income, as well as reasonable growth, are attracted to dividend stocks.
What companies pay dividends?
Dividends are usually paid by companies who have a slow, steady growth. These companies will not get the same "bang for their buck" by reinvesting in their business. This means to increase shareholder value they will either buy other companies (growth through acquisition) or they will pay dividends – sometimes both.
Why do companies increase dividends?
Companies increase their dividend yield for one of two reasons. The most common reason is that their net profits are increasing. As net profits increase, there is more money to return to shareholders. A second reason is that a company may have a change in strategy. In many cases, a company that is issuing a dividend is still making investments to spur growth and expansion. However, if the company is forecasting an economic slowdown, they may choose to put less money into capital projects. On the opposite end of the spectrum, a rapidly growing company may want to consolidate its capital gains and reassess its market position before continuing its growth strategy. A company may also simply decide to increase its dividend yield to attract more equity investors. In all cases, the choice to increase a dividend means that a company is leaving a larger portion of their profits available to be returned to investors as dividends.
Understanding dividend yield and dividend payout ratio
The dividend yield is the ratio of a company’s annual dividend compared to its share price represented as a percentage. To calculate dividend yield, let’s look at this example:
- Company A announces a $2 per share annual dividend. The stock costs $40 per share.
- Company B announces a $1 per share annual dividend. Their stock also costs $40 per share.
To calculate the yield, you would simply divide the announced per share annual dividend by the share price.
- For company A, that would be 2/40 = 5%
- For company B, that would be 1/40 = 2.5%
Simply put, investing $10,000 in Company A would produce $500 of annual dividend income. That same $10,000 in Company B would produce $250 in annual dividend income. Assuming all other fundamentals were the same, income-oriented investors would prefer to invest in Company A because of the higher yield.
The dividend payout ratio(also known as simply the payout ratio) gives investors an idea of how much profit a company is returning to shareholders as opposed to how much money they are keeping on hand for reinvestment, to pay off debt, or to hold as cash (i.e. retained earnings). The formula for the dividend payout ratio is as follows:
- Dividend Payout Ratio = Dividends Paid/Net Income
Some companies will payout 100% of their income to shareholders. An investor should expect a company’s payout ratio to be higher if they are a mature, established company. When a company has a high percentage of retained earnings, it can try the patience of investors.
How to invest in stocks with increasing dividends
Step One: Choose wisely
Once you’ve looked at a company’s dividend yield and dividend payout ratio, it’s still important to choose wisely. Although a dividend is generally considered to be a sign that a company is healthy, that is not always the case. Keep in mind that a dividend is an alternative measure of capital growth. Growth investors would rather invest in companies that are generating impressive revenue and plowing that money back into their business to stimulate even more growth.
A company like Coca-Cola has continued to grow year after year (it’s a favorite of Warren Buffett). Coke’s appeal is in a dividend that is both consistently being issued and is growing every year.
But just because a company has a reputation for offering a dividend, investors should still expect a level of dividend growth. IBM issues a nice dividend of around 4.5% per year. However, the stock has been battered for several years and was showing negative capital growth. So even if investors were reinvesting their dividends, they would not be seeing a large total return from holding that stock.
Also, remember that just because a company announces a dividend does not mean they have to pay it. This is not common, but some companies will announce a dividend, usually with a very attractive yield, to entice investors. But if the company runs into financial difficulty, any dividends are usually the first thing to get cut.
Many companies have a solid track record of raising their dividends. The best of the best have royal titles: princes, aristocrats, and kings.
- Dividend princes have raised their dividend for at least 10 years.
- Dividend aristocrats have raised their dividend for at least 25 years.
- Dividend kings have raised their dividend for at least 50 years.
These companies are very attractive to investors. Any company that has both the desire and the ability to generate increased dividend payments for its shareholders is a stock worth considering for an investor's portfolio. Dividend stocks are regarded as defensive stocks because of their ability to weather the volatility of both bull and bear markets. Put another way, most of these companies are in industries where consumers and businesses will always have a need for their products or services. The ability of these companies to increase their dividend for at least 10 years means that many of these companies have a strong, competitive advantage.
Step Two: Look to reinvest dividends
Many, but not all, dividend-paying companies allow individuals to reinvest dividends through a dividend reinvestment plan (DRIP). Automatic reinvestment is a strategy for investors who do not need regular income that is generated by dividends.
Here’s a simplified example of how a DRIP works. Company XYZ has a share price of $25 per share and a dividend yield of 5%. If an investor buys 100 shares, they will earn a yearly dividend of $125 ($2,500 x 5%). If they choose to reinvest that dividend, at the end of the year they will have purchased an additional five shares of Company XYZ stock and the value of their holdings assuming the share price remained at $25 would be $2,625. It’s a wash, right? But what if the share price climbs to $30 by the end of the year? Assuming the dividend yield does not increase, the payout would be $125, but the 105 shares would now be worth $3,150.
Some companies allow investors to put in additional money (with some minimum and maximum restrictions). An investor will typically pay the market price for those shares, although some companies will sell these shares at a slight discount.
There are two caveats for investors looking to buy additional shares separate from dividends being reinvested. First, is that it can take some time to sell the shares that you buy directly from the company. Second, it is important to remember that every dividend reinvestment represents shares that are being purchased at a different price. This means that the capital gains are going to be different for every transaction. Therefore, when you go to sell these shares all of those capital gains have to be accounted for.
Step Three: Look at dividend mutual funds and ETFs
Investing in a dividend mutual fund or ETF is a good option for beginning investors and investors who don’t want to take the time to choose their own stocks or track individual stocks once they buy them. These funds are typically comprised of multiple dividend-paying stocks. If you believe in the idea of not putting all your eggs in one basket, this may be a great option.
However, choosing a fund can be like walking into a Baskin-Robbins. There are a lot of varieties and it’s still up to you to decide on which funds are right for you. You'll want to look at the stocks that are included and check their dividend yield, their consistency with paying the dividend over time, their expense ratio (low is good) and the size of the company, or market capitalization. From lowest to highest risk, there are large caps, mid-caps, and small caps.
Why do companies cut their dividends?
If dividends are attractive to some investors why do companies cut their dividend? As we mentioned above, a company that is not rapidly growing may take on debt to spur growth. If the company takes on a lot of debt in a short time, the dividend may have to get cut for the company to service the payment of the debt.
Beware of chasing a yield
One trap that can befall dividend investors is chasing high yield. In some cases, a company's dividend yield exists for good reason. But in some cases, the high dividend yield is a warning that the company is not financially stable. That’s why it’s always good to follow the strategy of looking at a company’s fundamentals to understand if their dividend yield and/or payout ratio is sustainable and also looking for companies with a history of increasing yields.
The final work on investing in stocks with increasing dividends
Investing in dividend stocks is a time-honored way of growing wealth slowly. Following the simple three-part strategy of choosing a company wisely, looking to reinvest your dividends, and if necessary investing in dividend mutual funds and ETFs are good ways to identify and take advantage of dividend stocks that are increasing their dividends regularly. Dividend investing is not about chasing the highest yield you can find. There are often reasons why a company is offering a high yield. Like many things in life, if it looks too good to be true, it usually is.
