Dividend growth investing is a popular investment strategy among more aggressive income investors.

As a quick reminder, cash-generative businesses sometimes return excess capital back to shareholders in the form of dividends. For the firm, this helps maintain a stable stock price that can be used to potentially raise money via equity in the future. For investors, dividends provide a stream of passive income.

A common trait among dividend-paying stocks is a lack of growth. But that’s not always the case. And a dividend growth investor seeks out companies that not only pay a stable and reliable dividend but also consistently increase it.

How does dividend growth investing work?

Strong businesses can sometimes generate a lot of organic growth without needing significant internal investment. It’s a rare trait to come by, but it’s exactly what a dividend growth investor looks for.

Finding such dividend growth investing opportunities in their infancy can be a serious challenge. After all, younger businesses are more prone to disruption. That’s why most investors instead focus on the companies that have already proven their ability to raise shareholder payouts each year throughout history consistently.

For both the London Stock Exchange and New York Stock Exchange, there are various lists of companies that are popular among individuals following the dividend growth investing strategy.

• Dividend Challengers – Increased shareholder payout for more than five years in a row.
• Dividend Achievers – Increased shareholder payouts for ten years in a row.
• Dividend Contenders – Increased shareholder payouts for more than ten years in a row.
• Dividend Champions – Increased shareholder payouts for 25 years in a row.
• Dividend Aristocrats – Increased shareholder payouts for more than 25 years in a row.
• Dividend Kings – Increased shareholder payouts for more than 50 years in a row.

Building a dividend growth portfolio

Investors can find potential candidates for a passive income portfolio using these stock lists. However, there remain further steps to the stock-picking process.

Most dividend aristocrats are not content with losing their hard-earned status. Consequently, management may make poor capital allocation decisions to maintain dividends at the cost of long-term value creation. Furthermore, not all dividend aristocrats can make meaningful increases to shareholder payouts and may only boost dividends by a single penny or cent each year to retain their title.

Investors need to spend time analysing historical growth rates to see if there are trends of dividend growth slowing or accelerating. In both cases, further investigation is required in order to determine whether there is a brewing issue or if increases can be sustained in the long run.

For example, there have been numerous cases of dividend aristocrats taking on debt to maintain dividends. Needless to say, this is not sustainable in the long run. And in extreme cases, it can send a once revered income stock to the brink of bankruptcy.

Additionally, income stocks rarely provide much growth in terms of the share price. Therefore, to ensure the creation of wealth in real terms, investors following a dividend growth investing strategy need to compare the dividend yield against the estimated inflation rate in the future. A yield offering returns lower than inflation will not increase an investor’s wealth in terms of spending power.

As with any investment portfolio, diversification is vital in managing risk. The impact of a sector- or economy-specific disruption can be mitigated by picking high-quality dividend growth stocks across multiple industries and geographies. This is especially important given the indefinite buy-and-hold investing style this strategy employs.

How to calculate dividend growth rate

The dividend growth rate of a stock can be calculated by comparing the dividend in the current period against the dividend in the previous period.

Let’s look at a made-up example for XYZ Corp.

Looking at the Dividend Per Share, the firm has increased its dividends substantially over the last half-decade. And it’s undoubtedly been a lucrative passive income investment for shareholders.

However, when looking at the Growth Rate, the increases in shareholder dividends have been consistently falling each year. This slowing trend may indicate that the firm could struggle to offer future increases. Therefore, an investor considering this business as part of their dividend investing strategy must investigate what’s causing the slowdown and determine whether it will continue moving forward.

How to calculate dividend yield

As mentioned, income investors need to focus on companies offering an attractive dividend yield that sits above expected future inflation. The yield tells investors what level of return dividends currently offer in relation to a company’s stock price.

For example, if XYZ Corp offers a dividend per share of 72p and trades at a stock price of 1,650p, its dividend yield equals 4.4%. This means that investors can expect a 4.4% return on investment if the share price doesn’t move. This is higher than the 2.5% average rate of UK inflation. Therefore it may potentially be a lucrative investment in the long term.

Looking at the FTSE 100, the average dividend yield for the UK stock market sits around 3.5% to 4%. By being more selective in which income stocks to buy, it’s possible to achieve market-beating returns. After all, the higher the dividend yield, the greater the return on investment.

However, it’s important to note that a high dividend yield can also be a red flag. Because yield is derived from the share price, any sudden decrease in stock valuation will send the dividend yield up. Typically drastic declines in stock prices are triggered by significant problems that may compromise cash flow. If that’s the case, investing in a high-yield dividend stock may be a costly mistake, as a dividend cut may be on the horizon.

Advantages of dividend growth investing

Investing in dividend growth stocks can offer a lot of benefits to income investors.

• Generate Growing Passive Income – As these income stocks aim to increase their dividends over time, a relatively modest dividend yield can increase substantially on an original cost basis. As such, investors can enjoy a passive income stream that gets bigger every year, leading to substantial returns in the long run.
• Low Volatility – While volatility cannot be avoided entirely, dividend-paying stocks typically have superior share price stability. This can help reduce the overall risk profile of an investment portfolio.

Disadvantages of dividend growth investing

Establishing an investment portfolio that generates lucrative passive income is understandably desirable. However, there are some drawbacks that investors need to consider.

• Requires Patience – Investing in dividend growth stock is most suitable for investors operating on a long time horizon. The compounding effects of increasing shareholder payouts can take years or even decades to mature. Adopting this strategy when using it on a short timeline is likely a poor decision.
• Low Capital Gains – Income stocks can often provide lower levels of volatility. However, this also comes at the cost of lower capital gains. With large chunks of capital being redistributed to shareholders, less money is available for internal investment. As such, the share price of even dividend-growth stocks can deliver somewhat lacklustre returns.
• Dividends Can Be Cut – It’s important to remember that dividends are ultimately optional payments for businesses. As such, if cash flow becomes compromised, shareholder payouts may be cut, suspended, or even outright cancelled, causing an investor’s passive income stream to evaporate seemingly overnight.

The bottom line

Dividend growth investing is a long-term investment strategy that requires a lot of patience. However, given sufficient time, it can establish an impressive passive income stream that can lead to a more comfortable lifestyle, especially during retirement.

However, while dividend income stocks are considered less risky than traditional growth stocks, it’s important to remember that they aren’t risk-free. And even firms with an impressive track record of raising dividends can still issue cuts in the future.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.