What is Dividend Growth Investing (DGI)?

First of all, a company can choose to pay a dividend when it’s profitable. If the company is not profitable the only way to pay a dividend is by borrowing money, but this is obviously unhealthy and unsustainable. A profitable company re-invests most of its profit back into the company to generate even more profits, pay down debt, buy back shares, or distribute profits directly to shareholders in the form of dividends. Buying back shares means that the number of outstanding shares decreases, and the value of the remaining shares is growing, so each investor should see their stock grow in value over time. Paying a dividend means that the company pays a cash amount to each shareholder, usually every quarter, or even monthly.

As you can notice, a sustainable dividend is crucial for this strategy to work well. Therefore, the dividend is sustainable if the company is profitable and will continue to be profitable for a long time. Usually, a company is profitable if it generates a positive free cash flow (FCF). FCF is the amount of cash left after paying all the operating expenses and capital expenditures (CAPEX). This cash can be used to pay dividends if the company chooses to do so.

It’s also very important to look at how much of the earnings are used to pay those dividends. The metric you want to watch here is the payout ratio. The dividend payout ratio is the percentage of a company’s earnings paid out as dividends. A high payout ratio (e.g., above 70-80%) can be a red flag, suggesting the company may struggle to maintain its dividend if earnings decline. A very high yield combined with a very high payout ratio is a major red flag. A low payout ratio suggests the company is retaining a significant portion of its earnings for reinvestment or buybacks, which could lead to future growth. Consistent earnings growth is essential for future dividend increases. Companies that can consistently grow their earnings are more likely to raise their dividends over time.

Another important metric to look at is the dividend yield. It’s calculated by dividing the annual dividend by the current stock price. The higher it is, the less sustainable it is. Usually, a low dividend yield is considered to be under 2%, a decent one is between 2% and 4%, a big one is between 4% and 7%, and an unsustainable one is over 7% if the payout ratio is also very high.

Also, high debt levels can also strain a company’s finances and make it more difficult to maintain or increase dividends. Look for companies with manageable debt levels.

But don’t take these numbers as rules. No single metric can paint you the whole picture. If a stock is dropping in price because of panic in the market but you’re confident that’s just temporary, you might be able to buy a strong company with a high sustainable dividend yield.

The true power of DGI lies in the compounding effect of reinvesting dividends. Here’s how it works:

• you receive dividend payments
• instead of taking the cash, you automatically reinvest it to purchase more shares of the company
• these additional shares then generate even more dividends, creating a snowball effect

This process is often facilitated through Dividend Reinvestment Plans (DRIPs) offered by many brokers. DRIPs automate the reinvestment process, making it easy to compound your returns. A long-term time horizon is essential for maximizing the benefits of compounding. The longer you reinvest your dividends, the greater the impact on your overall returns.

And this is very important because even if the share price remains stagnant if the dividends are increased your passive income increases over time, without the need to invest more money. It helps offset inflation, ensuring your income stream maintains its value over time. Consistent dividend increases signal a company’s financial strength, profitability, and commitment to shareholder value. This provides a degree of stability and confidence in your investment.

While there’s no official standard, here are some common classification based on the number of consecutive years of dividend increases:

These companies grew the dividend every year for at least 10 consecutive years. There are other requirements for being part of this category, like being listed on the NYSE or Nasdaq and some minimum trading volume. The full methodology can be found here. You can find all the Achievers in this index.

These companies grew the dividend every year for at least 25 consecutive years, are members of the S&P 500, and have at least $3 billion in market capitalization. The full methodology can be found here. The full list of the Aristocrats can be found in this index.

This is the most exclusive category, reserved for companies with a remarkable track record of at least 50 consecutive years of dividend increases. These companies have demonstrated exceptional resilience, navigating economic downturns and continuing to reward shareholders even during challenging periods. The full methodology can be found here. The full list of the Kings (or Monarchs, how the S&P Global calls them) can be found in this index.

Compared to growth stocks, DGI stocks tend to appreciate in value more slowly. The focus is on steady income, not rapid capital gains.

Dividends are often taxed as income, which can reduce your overall returns, especially in non-tax-advantaged accounts.

Even companies with long histories of dividend increases can cut or suspend their dividends during economic downturns or periods of financial difficulty. This can significantly impact your income stream.

Rising interest rates can make bonds more attractive to income-seeking investors, potentially putting downward pressure on the prices of dividend stocks.

DGI is a long-term strategy. It takes time for the compounding effect of dividend reinvestment and dividend growth to make a significant impact.

Dividend growth investing is a long-term strategy that can provide a steadily growing income stream and long-term capital appreciation. By understanding the key principles, metrics, and potential drawbacks, you can make informed investment decisions and build a successful DGI portfolio.