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Income seeking investors are often focusing their attention on a share’s dividend yield. Which is not necessarily a bad thing and can work.
However, it has the potential of costing you several percentage of return or thousands of dollars each year. It’s a potential trap that many, including me, have fallen into and that many will still fall for. Yield is not the only metric you should be looking at to evaluate an dividend income investment.
There are some tips and tricks that you can use to ensure, on top of yield, that your investment is sound.
Growth, Growth and Growth.
Believe it or not, growth is much more important than a big yield. Dividend paying companies have historically given a higher returns. According to a Ned Davis research, dividend payers from the S&P 500 have produced an average total annual return of 9.25% since 1972 to 2018. Now if you look at the S&P 500 return of the same period, it has a 7.7% average total return. As such, we can easily see that dividend is paying!
| Group Name | Returns |
|---|---|
| Dividend growers and initiators | 10.07% |
| All dividend paying stocks | 9.25% |
| No change in dividend policy | 7.47% |
| Non-dividend paying stocks | 2.61% |
| Dividend cutters and eliminators | (0.35%) |
Source: 2018 Ned Davis Research Inc. Past performances does not guarantee future results. Indexes are unmanaged and one cannot invest directly in an index. All stocks were categorized by the following methodology for total return each 12-month period since Jan. 21, 1972 period ended Jan. 31 2018. Dividend Cutters and Eliminators represents stocks in the S&P 500 that have lowered or eliminated their dividend; Non-Dividend-Paying-Stocks, represents non-dividend-paying stocks of the S&P 500; Dividend Payers With No Change represents all dividend-paying stocks in the S&P 500 that have maintained their existing dividend rate; All Dividend-Paying Stocks represent all dividend-paying stocks in the S&P 500; Dividend Grower and Initiators represents all dividend-paying stocks of the S&P 500 that raised their existing dividend or initiated dividend. Performance doesn’t not represent any unit trust or strategy.
Also, looking at the same data, it shows that the Dividend Growers and Initiators have an average annual return of 10%!
As such, you, as an investor, should look past a stock’s yield and you should be looking at growth and dividend growth prospect.
Why?
Because in the long term, such growth will earn you a far larger return than buying and selling stocks. You need to choose your investment wisely to include companies that have, not only, a solid history of dividend distribution but also a solid history of dividend growth.
Pepsi Co (PEP) is a really good example, it has increased it’s dividend year over year for the last 45 years! Calculating the total return for the last 30 years, with dividend reinvestment, is over 1900% which is well above the return of 1200% for the S&P 500 over the same period.
Good payout ratio, not too high.
Another good value to look at when you look at a dividend stock, is the dividend payout ratio. The payout ratio is the percentage of the company’s profit that is returned to the investors as dividends. The higher the payout ratio, the higher the money sent back to you. Also, higher yield dividend paying companies do have a higher payout ratio.
Why isn’t it a good sign you might ask?
Indeed, it’s a good question. If a company gives more of it’s money to you it should bring you more money right?
Research have proven that companies with payout ratios closer to 40 to 50% are outperforming the market more frequently.
As such, investors should be on the look-out for companies that have a healthy payout ratio but still keeps a meaningful portion of their profit/cash flow in house. This will provide the investor, you, with a good income, but will give the selected companies a nice margin of safety for future dividend but also let them reinvest in expansion plans for their business that will keep on growing their cash flow, and your income at the same time.
What’s in it for you
Dividend growth tends to produce higher total annual return on the long term then a simple dividend strategy.
As such, choosing and investing in companies that grows their dividend is a solid strategy.
Investors, such as you, should focus on companies that can bolster their payout in a consistent manner for a long time. As such, you should looking for business that make a priority not only on growing their dividend year after year, but that have a proven record at keeping enough cash to continue an expansion plan.
That extra cash will also give them the potential to weather any financial storms that the market can throw at them.
If you follow those tips, you will grow your portfolio and you will be able to make more money on the long run then just selecting big yield giving companies.
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