Dividend growth investing is based on the theory of building a portfolio of stable companies that are expected to pay out a continually increasing dividend for the foreseeable future. These companies generally are expected to return low capital growth rates as well, often in line with their dividend growth.

This cash flow stream of dividends acts as a source of income that can be used for living expenses or reinvested back into the portfolio, creating a compound growth effect. The nature of an increasing dividend means the income stream will be larger and larger every year, hopefully outpacing inflation and providing additional cushion on spending needs.

Of course, there are always risks associated with investing, and this strategy is no different. Companies will have hard times, and some will eventually decide to cut their dividend. The key to reducing that risk involves strategically identifying responsibly run companies that have strong future prospects with wide economic moats, and buying into these companies when they are undervalued to provide a large margin of safety.

This strategy has become popular in recent years, with lists of dividend “kings” or “champions” readily available to show all the stocks that have increased their dividends every year for 25+ years. The selection of investments comes down to more than just the dividend history though, as these companies can still fluctuate between being overvalued and undervalued. Finding key pricing metrics and understanding how the company compares historically as well as against its peers will help to identify the best opportunities at that point in time. Tracking and recognizing macroeconomic trends also helps to indicate areas of future strength or weakness and guide industry focus.

Dividend Growth Rates

Take a simple example of three stocks that all yield 3% today. Stock A grows its dividend at 10% annually, Stock B grows its dividend at 5%, and Stock C issues a steady, unchanging dividend. The graph below shows the Yield on Cost over the next ten years, assuming no reinvestment or changes in your original purchase of the stocks.

It is easy to see why growth rate is an important factor to take into account. Stock A’s yield grew by 159% while Stock B’s yield grew by 63%. Unsurprisingly, Stock C remains stuck at a 3% yield on your investment. Stock A has twice the growth rate of Stock B, yet the compounding of that additional growth leads to a difference in Yield on Cost that is much greater than double after ten years.