There is indisputable evidence to indicate that companies that consistently increase their dividends outperform those that don’t pay out dividends significantly in the long-term. Even if we go back to the 1970s, S&P 500 stocks that initiated then grew their dividends produced average annual returns of almost 10%.
This compares very favorably with non-payers who only delivered total annual returns of 2.39% in the same timeframe. It even compares well with companies that pay dividends but without regular increases, since their average total annual returns stood at 7.37%. It’s clear, then, that anyone who is keen to build up their long-term wealth should consider investing in stocks with a high dividend growth rate.
Yet, while purchasing stocks in companies with a history of consistently growing dividends is an ideal place for beginners to get started, it’s often better to put your focus on companies with the biggest potential of increasing their payouts regularly in the future. You should focus less on the current dividend yield of a company and more on its growth prospects and payout ratio.
In this guide, we’ll look at how you can identify the best stocks with a high dividend growth rate so you can make the right long-term investments.
High Dividend Growth Stocks – An Overview
Dividend growth stocks are companies that increase their dividends on a regular basis. While some of these companies increase their payouts quarterly or annually, others increase them less frequently. Nevertheless, to qualify as a dividend growth stock a company must increase its payouts a minimum of once per calendar year for several years in a row.
Of all dividend growth stocks, some companies offer higher dividends than others. The best high dividend growth stocks have four characteristics in common:
- They are mature companies producing consistent profits as well as free cash flow.
- They have healthy dividend payout ratios.
- Their balance sheet is strong and is often backed up by investment-grade credit ratings
- Their growth runway is still long.
What Should You Know About Dividend Payout Ratios?
A company’s dividend payout ratio represents the company’s cash flow percentage sent to investors every year. So if, as an example, the company makes $1 million of profits then pays half of that amount to shareholders in dividends, the payout ratio is 50%.
All payout ratios will vary depending on the company and its industry. Business in the early part of their growth cycle rarely pay dividends at all. Meanwhile, more mature companies that have limited prospects for growth often pay out large portions of their cash flow to incentivize investors to purchase their stock.
Payout ratios of over 0% but under 35% are good for most dividend growth stocks since it indicates the company is keeping a large proportion of its cash flow to reinvest in the business. This should allow cash flow to grow briskly and, thus, enable dividends to be increased over time. However, payout ratios between 35% and 50% are also often health, since the business will usually have plenty of excess cash available to reinvest.
Companies that have a high payout ratio of around 46% outperform the S&P almost 90% of the time. This is something that investors should bear in mind when choosing their investment options. You should also bear in mind, though, that higher payout ratios also generate a higher risk for dividends to be reduced in tough times.
Although payment ratios vary by industry, one general rule of thumb is to solely focus on those companies with payout ratios under 75% since this will reduce the chance of dividend cuts in the future.