Everybody wants to own a dividend champion. Many investors would love to be able to fund their retirement expenses from income, rather than from selling assets, so they don’t have to worry about selling into a down market. But what determines a dividend winner?
Many dividend investors often set minimum requirements for an “acceptable” initial dividend yield and/or dividend growth rate. Or, a combination of all three.
Thus one investor might say, “I won’t invest in a dividend paying company with a dividend yield of less than 3%.” Another might say, “I want a company that increases its dividend at least 10% per year.” A third might demand that any company he or she buys have increased its dividend for a minimum number of years in a row.
One of the primary goals in dividend investing is to purchase shares whose yields and dividend growth rates combine to generate better returns than ‘safer’ fixed-income investments like savings accounts, Gilts, and corporate bonds, which normally offer lower yields at less risk, as well as are comfortably ahead of inflation rate rises.
The dynamic that determines the long-term dividend return of a dividend paying company is how its initial dividend yield (that is, the yield at the time you buy it) interacts with its annual dividend growth rate.
For instance, a company with a 5% initial yield (at purchase) growing at 10% per year will achieve a set target return much sooner than a 2% initial yielder growing at the same rate. Conversely, a company with a 3% initial yield growing at 10% per year will at some point permanently surpass the dividend return of a 5% initial yielder growing only at 5% per year.
The question becomes, when do those lines cross? When do you have a dividend champion? And as an investor, are you comfortable with how long it takes for the faster-growing 3% yielder to pass the 5% dividend paying share growing more slowly?
Many dividend income investors have a long-term holding period in mind when they buy the shares of a dividend paying company. They are not looking to trade them often, but rather to hold them for the long term, allowing time for the dividends to increase and compound, until such share itself becomes a money-generating machine irrespective of the share’s price fluctuations.
Suppose your long term goal is to achieve a 10% yield on your purchase cost within 10 years. How realistic is this?
You can achieve this but only if you select shares that will generate a 10% dividend return on your original investment within 10 years’ time. The two 10s are arbitrary, of course. You can put in any goals you like.
So the question is reduced to some simple math: What initial yields, compounded at what rates of annual average growth, will achieve a 10% dividend return within 10 years?
The following table shows the initial yields and annual growth rates required to achieve this. Choose your dividend champion that will grow its dividends at rates of 4% to 13%, and purchase them when their dividend yield at purchase is the percentage shown below:
Now the tricky bit. Things are unfortunately never easy.
How to choose your dividend champion – the company that will grow dividends at an above-average rate over the next 10 years? One way is to consider the past for this, i.e. companies with a long history of increasing their dividends.
Unfortunately there are not that many companies listed on the London Stock Exchange that have a track record of increasing their dividends in all consecutive years for very long periods – I am talking 10 or even 12 years minimum.
There are some though, and as a subscriber of Dividend Income Investor.com you can access them.
The second question is, when do you buy these companies? How do you achieve the desired dividend yield at purchase?
Let me show this in an example.
Take company XYZ. Its current dividend is £1.08 per share. Because its dividend growth rate has been (and you ‘hope’ will continue to be no less than) 4% per year, for a long time, its dividend yield at purchase must be 7% (or more), which corresponds to a share price at purchase of £15.43 (or less) per share (1.08/0.07) = 15.43, or (1.08/15.43)*100 = 7% dividend yield.
But, is this a price level that the company shares can be considered historically undervalued? Check the company’s Dividend Value Profile at Dividend Income Investor.com.
Now you know whether, and when, to buy this company on the basis of this particular metric in order to achieve your goal of 10% yield-on-cost in 10 years.
Now for the really bad news.
Almost none of the FTSE350 companies can be purchased at current share prices and current dividend growth rates in order to achieve 10% yield-on-cost in 10 years. They are simply too expensive at current prices.
What to do? Either wait for share prices to fall or adjust your time frame and/or annual dividend growth rate.
An additional 1% in initial yield reduces by 2% to 4% the growth rate needed to reach 10% return in a given time. For instance, a jump in initial yield from 4% to 5% reduces the dividend growth rate needed to achieve the 10 by 10 goal by 3% per year.
This latter point is important. The faster you hit your 10% dividend return rate goal, the fewer years your dividend champion is subject to the risk that you have overestimated its rate of dividend growth.
As all dividend investors (should!) know, your initial rate of return is fixed at the time of purchase, but the future rate of dividend growth is somewhat speculative. Also, the higher the rate of projected dividend growth, the more risk that it may not actually be achieved.
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