How to Pick Dividend Growth Stocks (A Comprehensive Guide)

Investing in dividend growth stocks can be incredibly lucrative. But to be successful, you need to know how to pick dividend growth stocks, effectively.

In this post, I do my best to show you how.

I will go over the main aspects you need to take into account when picking dividend growth stocks.

As usual, I will share key nuggets of information that I have acquired throughout my investing journey. This includes the single best (and free) dividend growth stock resource.

And make sure you stick around to the end, where I synthesize it all into 10 practical and actionable steps!

A brief introduction to dividend growth investing

Dividend growth investing is investing in stocks that have a track record of not only maintaining but also raising their dividends every year.

Dividend growth stocks are beloved by investors because:

• They provide a stable, predictable and growing income every year
• They allow you to benefit from double compounding (exponential impact of reinvested dividends when combined with dividend growth)
• They have a tendency to generate capital gains in line with the dividend growth rate
• They fit the profile of the long term investor, which are still in the accumulation phase and don’t need to live off of a high yield today.

If you’re reading this, you’re probably already familiar with the advantages of dividend growth investing. 

So let’s dive right into how to pick dividend growth stocks!

And it all starts with…

Dividend growth investing resources

Screening for stocks with a dividend growth history is the best starting point when researching dividend growth stocks.

Thankfully, there are several free resources available for you to take advantage of. 

They provide comprehensive “screen-able” lists of dividend growth stocks along with associated metrics that are relevant for the dividend growth investor.

There are also some paid dividend growth screening tools but these are to be considered once your portfolio has grown large enough to amortize the cost.

I definitely recommend starting with dedicated dividend growth investing resources because they are the most efficient way to identify dividend growth candidates on which to do further, more detailed, research.

It definitely beats a scattergun approach or waiting for a financial media outlet to bring a dividend growth stock to your attention.

Dividend growth track record (dividend growth history)

Dividend growth stocks are classified according to their dividend growth track record. This track record is incredibly valued by dividend growth investors.

This is evident when looking at the fancy titles attributed to those with the best dividend growth history:

• Dividend Kings – S&P 500 companies that have paid increasing dividends for 50+ consecutive years
• Dividend Aristocrats and Dividend Champions – Companies that have paid increasing dividends for 25+ consecutive years. Dividend Aristocrats relate only to S&P 500 companies while Dividend Champions is a term typically applied to all stocks with this characteristic.
• Dividend Contenders – Companies that have paid increasing dividends for 10+ consecutive years
• Dividend Challengers – Companies that have paid increasing dividends for 5+ consecutive years

Important things to consider when looking at dividend growth history

With Dividend Kings (50+ years) and Dividend Aristocrats / Champions (25+ years), the dividend growth history speaks for itself. These stocks are without question committed to growing their dividends and will do their utmost to maintain that streak.

For Dividend Contenders (10+ years) and Dividend Challengers (5+) on the other hand, it is important to investigate whether the companies have cut the dividend prior to establishing this record.

For example, many companies cut their dividends after the Global Financial Crisis of 2009 and have managed to deliver consecutive years of dividend growth since then, during an unprecedented bull market.

If a current Dividend Contenders (10+ years) cut its dividend in the past before establishing this record, it is not necessarily a problem per se.

However, it is important to get an idea of the magnitude of the cut and how many years it took for the dividend per share to exceed the amounts distributed versus the cut.

For Dividend Challengers (5+) years, I would recommend avoiding such stocks as dividend growth investments if it turns out that they have cut their dividends prior to establishing a new record. I would wait until they reach the Contender status before evaluating them.

If the stock is a new dividend initiator, meaning that it has established 5+ years of consecutive dividend growth after initiating a dividend for the first time, then this could be a great opportunity to “get in on the ground floor”.

They should definitely be considered but keep in mind that they don’t have as much of a stake in maintaining this streak going forward.

All else being equal, you want to prioritize companies with the longest dividend growth track record and those that have never cut their dividend.

Dividend growth rate and dividend yield

While a long track record of dividend growth is incredibly important when it comes to dividend growth investing, it is equally important to investigate the dividend growth and yield profile of your investment candidates.

Generally, large and mature companies with a long dividend growth track record do not have as much ability to grow earnings at a fast pace due to the “law of large numbers” and as such exhibit slower dividend growth rates.

They typically reward shareholders with higher dividend yields because the opportunities to reinvest in the business, for growth, is somewhat limited.

Conversely, companies with a relatively large growth runway ahead of them, and that are still reinvesting the majority of their earnings back into the business, will choose to distribute a lower amount to shareholders.

They typically have shorter dividend growth track records but will have the potential to substantially grow dividends over time, as the company continues to grow and approaches maturity.

The key take-way here is that there usually a trade-off between yield and growth.

The Holy Grail is high yield and high growth. Do keep a lookout for such opportunities because, occasionally, they do arise!

Needless to say, avoid low yield and low growth.

You are free to choose the yield and dividend growth profile that suits your portfolio requirements.

Personally, I don’t restrict myself to a particular yield and dividend growth profile and just choose to seize opportunities as they present themselves.

Dividend safety and dividend growth sustainability

While dividend growth history and historical growth rates may indicate that a company has successfully delivered on its dividend growth policy in the past, they are just a starting point.

It is important to dig deeper in order to establish whether you have reasonable confidence of dividend safety, going forward.

Let’s go over some key aspects I look at to try and determine whether a company will be able to continue to grow its dividend for the foreseeable future.

Dividend Payout Ratio

The Dividend Payout Ratio (DPR) is calculated as the total amount of dividends distributed to shareholders divided by total annual company earnings. It can also be calculated as the dividend per share divided by Earnings per Share (EPS).

A similar metric is the Free Cash Flow Dividend Payout Ratio. It is calculated as the total amount of dividends distributed to shareholders divided by the total annual free cash flow.

In my view the Free Cash Flow ratio Dividend Payout Ratio is a superior metric because it directly related to cash and dividends are, after all, a cash payment.

Regardless of the metric you choose (I suggest calculating both of them and investigating the reason for any major discrepancies), the lower the ratio, the more leeway the company has to increase dividends in the future, particularly if earnings are growing as well.

When analyzing payout ratios, make sure to take averages over the last 3-5 years and to always be a bit more conservative than the latest numbers. You never know what the future holds and you don’t want to be caught flat footed because the company happened to have a one-off exceptional year. 

You should avoid really high DPRs (e.g. in the 85-100% range or above) because they leave very little room for growth and increase the risk of a dividend cut if the company finds itself in difficulty.

DPRs in the 70%-85% range should leave room for low single digit growth that matches inflation but you should make sure that you are receiving enough yield to compensate for the lack of growth.

DPRs in the 10% to 60% range should leave room for considerable dividend growth that handily beats inflation. 10% being better than 60% in this regard of course. 

My point here is that you can successfully invest across different DPR ranges.

You just need to make sure that you’re getting paid enough yield relative to the Dividend Payout Ratio. This is incredibly important.

Let’s say I have two investment opportunities:

• Company A,  paying a 5% dividend at 80% DPR and
• Company B, paying a 2% yield at 40% DPR.

All else being equal (earnings growth in particular), I would pick the 5% dividend stock because if the other company increased its DPR to 80%, it would only be able to pay a 4% yield. If I expect a 6% yield for an 80% DPR, then none of them will do. 

It is a crude but quick way to assess the DPR relative to yield.