Dividend Growth: Everything You Need To Know
When it comes to dividend growth investing, you want to make sure that you are choosing your dividend growth stocks correctly.
If you’re a budding dividend growth investor, or strongly considering this proven investment strategy, one thing is clear.
You need to make sure that you fully understand dividend growth and its implications. And I emphasize the word fully.
In this post, I dissect dividend growth in detail, and from different perspectives, to arm you with the knowledge you need to be a successful dividend growth investor.
So that you can make the right decisions, for you.
And with that said, let’s dive right in.
Dividend growth and Yield on Cost
If you’re serious about dividend growth investing, then you’ve probably already come across of the concept of Yield on Cost.
Yield on Cost (YoC) is a metric that clearly demonstrates the power of dividend growth. It is calculated by dividing the current annual dividend by the price you initially paid for the shares (cost basis).
After several years, as the dividend continues to grow, and assuming your cost basis remains the same, your Yield on Cost will increase.
Let’s go over a quick example. Below is a table showing the Yield on Costs you would achieve after holding an investment for a period of 5 years for a certain Current Yield and a certain constant Dividend Growth Rate:
As you can see, if you buy a stock with 2% Current Yield today and it exhibits a Dividend Growth Rate of 10% annually for the next 5 years, after 5 years you will have a YoC of 3.22%.
Of course, the greater the current yield and the greater the dividend growth rate, the greater your Yield on Cost will be.
Below I provide additional tables, for your reference, related to holding periods of 10, 15 and 20 years respectively.
Clearly, all else being equal, increasing your holding period can dramatically increase your Yield on Cost.
However, apart from demonstrating the power of dividend growth, the value of Yield on Cost is quite limited.
Many dividend growth investors overemphasize this metric in their portfolio and rationalize continuing to hold their dividend growth stocks because of this measure.
“Why would I sell an investment that is providing me a 15% Yield on Cost?” you might ask.
To which I would respond “what is the yield today, if someone were to buy the stock right now?”
You see, if that same stock is currently yielding 2%, you could sell it (for huge capital gains since the price is much higher right now for it to yield 2% on current price instead of 15% on your cost basis).
And you could buy a stock currently yielding, let’s say, 3% and increase your future income substantially as a result.
When making decisions on a dividend growth stock you own, consider the Yield and Dividend Growth prospects of your stock today and not what they were when you bought it years ago.
Not selling a stock solely because you are enamored with your high Yield on Cost could lead you to make the wrong decision.
Dividend growth and the Safe Withdrawal Rate
While Yield on Cost may have limited value when analysing your current portfolio, especially in informing your decision to hold or sell an investment, I am in the camp that believes that it can play a small part in helping you evaluate whether to buy a dividend a growth stock in the first place.
Particularly if you are striving for financial independence, which is probably your ultimate objective if you’re a serious dividend growth investor.
If you’re a financial independence enthusiast then you’ve already heard of the Safe Withdrawal Rate.
The Safe Withdrawal Rate (SWR) is used to determine what percentage of your portfolio value you can withdraw annually as income, to live off, while ensuring a very high probability that you will not run out of money before you depart this earth.
Ideally, you want every stock you buy today to help you deliver the right level of income you need when you’ll eventually reach financial independence.
One way of looking at it, is to ensure that the dividend growth stock you buy today, will at the very least growth its dividend sufficiently going forward so as to provide you with a Yield on Cost that is equal to your Safe Withdrawal Rate.
The most common SWR used is 4%. It is based on the famed Trinity Study also known as the four percent rule.
Below is a table showing the annual Dividend Growth Rate you would need to achieve a Yield on Cost equal to your Safe Withdrawal Rate of 4% for a certain Current Yield and a certain Holding Period (in years):
For example, if you are planning to reach financial independence in 15 years and currently considering a dividend growth stock with a Current Yield of 2%, it will need Dividend Growth Rate of 4.73% (annually and on average) for it to reach a Yield on Cost equivalent to SWR of 4%.
Below I provide additional tables, for your reference, related to SWRs of 3% and 5%:
It is important to note that all the tables I have presented do not consider inflation, and inflation, as you might suspect, is not to be neglected.
To account for inflation, simply add your expected annual inflation rate (e.g. 2%) to the growth rate you need to reach your target.
Looking at Yield on Cost from the perspective of it being equal or above your Safe Withdrawal Rate does not negate the fact that YoC is not the right metric to look at.
As I’ve mentioned earlier, you need to consider the yield and dividend growth prospects of a stock, today.
But it could be a way to justify keeping a stock in your portfolio, if you happen to be a long term investor, who plans to never sell a stock as long as it keeps paying a sustainable dividend and has achieved your YoC/SWR threshold (at a minimum and adjusted for inflation).
Clearly, this is just a matter of comfort and personal preference.
And I’m not minimizing this fact. It’s critical to be comfortable with what you own and to SWAN (Sleep Well At Night).
I actually mostly use this approach myself for the dividend growth portion of my portfolio.
But I am aware of the fallacies of this approach and I am also aware that there is a much more powerful lens through which to look at dividend growth…
Dividend growth and Total Return
Let me start off by saying that total return, on a risk-adjusted basis, should probably be your main focus when you’re in the accumulation phase of your investing journey.
The reason for that should be clear. You don’t need to spend the income today. The more returns you get (no matter the source: income or capital gains and tax considerations aside) the bigger your portfolio gets.
And the bigger your portfolio gets, the more income you’ll ultimately be able to generate when it’s time to draw on your portfolio.
You’ll be able to sell some of your now (hopefully) highly appreciated and lower yielding shares into higher yielding investments.
Let’s link this back to dividend growth, it’s the subject of this post after all.
The Chowder Rule, a proxy for total return
The Chowder Rule basically states that the sum of the dividend growth rate and the dividend yield can be used to compare the total return potential of different dividend growth stocks:
It was developed by a Seeking Alpha contributor going under the name of Chowder who has now become a legend in the dividend growth community.
For example, a stock with a 2% dividend yield and a 10% dividend growth rate will in theory provide the same total return, 12% or a Chowder Number of 12, as a stock with a 4% dividend yield and an 8% dividend growth rate.
To estimate the dividend growth rate, there are a few different techniques you can use:
- The past 5 year average dividend growth rate, or the 3 year or the 10 year.
- Using the average of the past 1 year, 3 year, 5 year (and why not even 10 year) dividend growth rates
- Using the minimum of the past 1 year, 3 year, 5 year (and why not even 10 year) dividend growth rates
Simply add that estimated dividend growth rate to the yield of a stock and you get the Chowder Number.
Now you can compare Chowder Numbers and invest in the dividend growth stocks with the highest Chowder Number (i.e. total return potential).
One thing to note when employing the Chowder Rule, is that “a bird in the hand is worth more than two in the bush.”
So a 3% yielding stock growing its dividend at 7% would be more attractive than a 1% yielding stock growing its dividend at 9% because the current yield is certain and tangible. Tax considerations aside!
The main drawback with the Chowder Rule, is that it uses backward looking dividend growth rate estimates to determine the future dividend growth rate.
And as we all know, past performance is not a predictor of future results. This also applies to dividend growth rates.
The real driver of total return
In the real world, a dividend growth stock will only deliver high total return if its dividend growth is a symptom of high earnings and/or free cash-flow growth, and you buy it at a reasonable valuation.
It makes sense when I put it that way doesn’t it?
So technically, a better way to look at the future dividend growth rate, albeit harder to do, is to try and estimate the longer term future earnings/cash-flow growth rates, since these are much more likely to result in commensurate and sustainable dividend growth.
It’s all about the fundamentals of the company. If the fundamentals are strengthening and growing, then the dividend growth will more or less proportionately follow
So to conclude, if you’re a dividend growth investor in the accumulation phase, focus on dividend growth stocks with acceptable, and reasonably likely, earnings and cash-flow growth and the magic will happen.
And that is the true reason why, if you do this right, you’ll be able to brag about a high Yield on Cost.