The stock market is a tricky place to navigate. There are countless ways to invest, and it can be difficult to know which strategy will work best for you.
One of the most popular strategies is dividend growth investing. This blog post will help you understand how dividend stocks work and why they’re the key to funding your best life, for life.
What is a Dividend?
A dividend is a payment made by a company out of its earnings to shareholders. Dividends are a great source of passive income and can be the foundation for a dividend growth portfolio.
Essentially, dividends are payments that give you an additional return on your investment because they provide cash flow from sources other than just share price appreciation.
Dividends can be paid in cash, or they can be reinvested in the company to buy more shares.
Reinvesting dividends is a good way to increase your dividend income and grow your portfolio over time without spending any additional money.
For example, if you bought 100 shares of stock for $25 each – investing a total of $2,500 – that pay an annual dividend of $2 each, you would generate $200 in dividend income over the course of a year.
But if you reinvested that $200, then your investment would grow to $2,700.
That strategy works especially well when it comes time to sell because shares are worth more than what you paid initially due to the reinvested dividends.
If you invest in dividend-paying stocks, then the cash that’s paid as a dividend is always yours to do with as you please: You can take it and put it into your savings account for safe keeping; or they can be reinvested in the company to buy more shares.
What is Dividend Yield?
Dividend yield measures the annual income generated from dividends in terms of dollars per share expressed as a percentage.
The dividend yield formula is dividend per share divided by the current stock price.
For example, if a company pays out $1.50 in cash dividends and you buy 100 shares of the company’s stock at $25 per share for total investment of $2,500 then your dividend yield is 0.06 or 6%.
You just calculate it this way:
Annual Dividend per Share / Share Price.
The dividend itself doesn’t change, but the yield simply decreases as the share price goes up and increases when the stock falls in value.
Said another way, the dividend yield is higher when the share price is low and lower when the share price is high.
Once you buy the stock though, you lock in a share price and that’s known as your cost basis.
For example, if you buy 100 shares of stock for $25 each, your cost basis is $25 since it’s expressed per share.
What is Cost Basis?
The price you pay for a stock is known as your cost basis.
The cost basis doesn’t change if the stock goes up or down in price.
In fact, because you locked in a share price when you bought, you also locked in a dividend yield and that’s known as your yield on cost.
For example, if I buy a stock at $23 a share and it pays $1.50 annual dividend per share, my yield on cost is 6.5%.
What Is Dividend Growth Investing?
Dividend growth investing is about finding dividend stocks that increase their dividends over time.
We call that dividend growth and it’s just like a pay raise.
Just like employers give regular raises to employees, dividend stocks will give regular raises to their shareholders.
Over the last 30 years, the stocks that pay dividends raise their dividends on average 5.4% a year.
And that means that our investment earns more money as time goes by.
I’ve held shares in AT&T since 2012.
I originally bought the stock at $30.50 when it was paying a dividend of $1.76 a share locking in a cost basis of $30.50 and a yield on cost of 5.8%.
By 2020, AT&T had increased their dividend to $2.08 a share so my yield on cost increased to 6.8%. That’s a 17.2% increase over 8 years and is considered a high dividend yield.
There is another way we can squeeze more cash flow out of our dividend growth investing – by giving ourselves a dividend raise.
Because of that inverse relationship between share price and dividend yields, we can increase our dividend payout when share prices drop.
A perfect example of this happened when the stock market crashed back in March 2020.
In 2019, I had purchased shares of TriplePoint Venture Growth at $14 a share.
The shares paid $1.44 a year in dividend income and because it was already paying a high dividend yield of 10.3% due to its IRS status, I wasn’t expecting much in the way of raises.
But then COVID-19 hit and just like most companies, TriplePoint Venture Growth shares got hit hard dropping down to $5 a share!
So, I decided to give myself a raise by buying more shares at $5 to lower my cost basis and increase my yield on cost.
The average price of the shares I own is called a blended cost basis and since I owned shares at $14 and shares at $5 my blended cost basis is now $9.50.
And my yield on cost went from 10.3% to a whopping 14.7%.
That’s a growth rate of 42.7%!
This is why dividend growth investing works so well in any kind of market.
What is the Dividend Growth Rate?
A dividend growth rate is the percentage increase in a company’s dividend (payout) over time.
It’s one of the three factors we use in my Infinite Income program to determine if a dividend stock has a likelihood of increasing our dividend in the future.
If a company has a negative dividend growth rate, that means they have a history of reducing their dividend and we want to stay away from those.
If the dividend growth rate is positive, that means the company has a history of increasing the dividend and it qualifies as a dividend growth stock.
What is the Dividend Growth Formula?
The dividend growth formula is a formula that predicts the future dividend per share with a given annual dividend.
It is used by investors to help them figure out what an appropriate purchase price for stocks will be, and how much profit they can earn in dividends over time.
This is the best explanation of the formula to figure out the dividend growth rate courtesy of Investopedia…
A company’s dividend payments to its shareholders over the last five years were:
- Year 1 = $1.00
- Year 2 = $1.05
- Year 3 = $1.07
- Year 4 = $1.11
- Year 5 = $1.15
We can see that the dividend is definitely increasing over time, but we want to know the percentage increase. Because we’re curious like that.
To calculate the growth from one year to the next, you can use the following formula:
Dividend Growth= Dividend YearX /(Dividend Year(X – 1)) – 1
The answers from the back of the book:
- Year 1 Growth Rate = N/A
- Year 2 Growth Rate = $1.05 / $1.00 – 1 = 5%
- Year 3 Growth Rate = $1.07 / $1.05 – 1 = 1.9%
- Year 4 Growth Rate = $1.11 / $1.07 – 1 = 3.74%
- Year 5 Growth Rate = $1.15 / $1.11 – 1 = 3.6%
The average of these four annual growth rates is 3.56%. To confirm this is correct, use the following calculation:
$1 x (1 + 3.56%) 4 = $1.15
But that looks way too much like 9th grade algebra to me and I still have nightmares about it, so here’s an easier way.
Go to PercentageCalculator.net and calculate the percentage increase this way…
Then just add 5 + 1.9 + 3.74 + 3.6 and divide the total by 4 to get your average of 3.56.
How Much Do You Have to Invest to Live Off Dividends?
The answer to this question really depends on how much money you need to live your best life.
That’s why one of the first questions I ask potential financial coaching clients is…
“In an ideal and realistic world, what would your monthly income in retirement need to be to make you feel super happy, safe, and secure?”
And we build a retirement investing plan based on that answer.
Most of my clients are looking for $10,000 a month in (tax-free) retirement income.
They can easily live off dividends only if they have just $1,000,000 invested in stocks paying an average 12% dividend yield.
That’s why I think Suze Orman is insane to scare people into thinking they need a $10 million portfolio to retire.
It’s also why I think Warren Buffett is a hypocrite. Even though he only invests in companies that pay a dividend, he does not make dividend payments to his Berkshire Hathaway shareholders.
Best Stocks for Dividend Growth Investing
If I’ve sold you on the idea dividend growth investing, then you need to be looking for stocks with high dividend yield so that you can give diversified portfolio a head start.
The average dividend yields from stocks in the S&P 500 index is just 1.5% so it’s not that difficult for an investor to find dividend payments higher than that.
If my portfolio only paid yields of 1.5%, I would not have been able to retire at 50!
So, where do you find stocks that are best suited for dividend growth investing?
Here’s a list of dividend growth stocks stocks yielding at least 3% who have a 3-year dividend growth rate of at least 10%:
Are these the absolute best dividend growth stocks for your dividend paying portfolio?
It mainly depends on how much time you have before retirement and if the companies have good management and financial fundamentals including a reasonable dividend payout ratio, good earnings, and more.
Can You Lose Money On Dividend Stocks?
Yes, you can.
As with any investment, there is always risk.
Heck, you’re probably even losing money right now on your savings account if the interest rate on your money isn’t higher than the inflation rate.
The biggest risk associated with dividend paying stocks is that the companies will drastically reduce or eliminate their dividend altogether.
But one great thing about dividend stocks is that the income is paid based on the number of shares you own, not the value of those shares.
So, if I buy a stock at $20 and it pays $1 , the stock price can fall to $5 a share and it will still pay that $1.
So, in that sense dividend stocks – especially as a long term strategy – make more sense than stocks that don’t payout dividends.
If the market falls, my dividend stocks will still payout the same amount of income as they did when the market was booming.
You can’t say that if you’re investing in stocks just for price appreciation.
Time is of the Essence
Dividend growth investing is a long-term investment strategy.
The bottom line is the sooner you get started, the more growth you’ll see from your portfolio and the more money you’ll have in retirement.
So, if you’re considering dividend growth investing by adding dividend paying stocks to your portfolio, don’t delay.
And if you need some help with personal finance and becoming an investor who is in it for the long-term with dividends then check out our case study and let’s talk.
Your future self is depending on you to get this right.