There is no one best way to invest. Every investment strategy offers potential rewards and poses certain risks. The appropriate strategy or strategies for you depends on your personal goals, financial circumstances and risk tolerance. However, one strategy worth considering is dividend growth investing — or investing in companies with a solid record of paying regular, increasing dividends.
While there are no guarantees, dividend-paying companies are often viewed as more stable and less volatile than other companies. Stock prices generally fluctuate, often as a result of factors unrelated to a company’s underlying performance. Dividend growth can be a better way to determine a company’s financial strength and future outlook while benefiting from their cash flow.
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Significant contribution to returns
When evaluating market returns, many investors focus exclusively on price appreciation. Historically, however, dividends have been a significant component of total returns; therefore, both should be considered to appropriately measure performance.
A recent study by Hartford Funds examined the impact of dividends on the S&P 500 Index from 1960 through 2021. Over that period, the contribution of dividend income to total returns averaged 40%. The study also revealed that 84% of the S&P 500’s total return over the same period is attributable to “reinvested dividends and the power of compounding.” Hartford also reported that, going back to 1973, the stocks of companies that consistently grow their dividends exhibited higher returns and lower volatility than stocks of other companies.
Growth vs. yield
It is important to understand the difference between dividend growth and dividend yield. Yield is the annual dividend per share as a percentage of a stock’s price per share. So, for example, if a company’s annual dividend is $5 per share and its stock price is $100, its dividend yield is 5%. Dividend growth, on the other hand, measures the percentage change in dividend payouts from one year to the next. If a company pays a dividend of $5 per share in year one and $5.50 in year two, dividend growth is 10%.
While dividend yield can be a relevant metric, dividend growth usually is a better indicator of dividend trends over time. Suppose, in the above example, that the company’s stock price falls to $50 in year two and that its dividend per share drops to $3. In that case, the company’s dividend yield actually increases to 6%, but its dividend growth rate falls to -40%. Typically, companies that regularly increase dividends also regularly increase earnings.
Behind the numbers
Healthy dividend growth can be a good indicator of a stock’s potential, but there are no guarantees that dividends will not be cut or that stock prices will not drop in the near future, which could impact the stock’s price as well as investor cash flow. Rather than relying on dividend growth statistics alone, it is important to look behind the numbers to assess whether a company has a strong balance sheet, healthy cash flow and a management team that is committed to maintaining dividend growth while reinvesting in the company. According to Hartford, “corporations that consistently grow their dividends have historically exhibited strong fundamentals, solid business plans and a deep commitment to their shareholders.”
One useful metric in evaluating dividend growth potential is the payout ratio. This is the percentage of a company’s net income that is paid out in the form of dividends. A company with a high payout ratio — one that is earning barely enough to cover its dividend payouts — may be vulnerable to economic or competitive pressures down the road, leading investors to consider alternatives.
Income tax impacts
Where there is income, income tax tends to follow; however, not all income is taxed at the same rates. Qualified dividends generally qualify for long-term capital gain tax rates which are often lower than rates on ordinary income. Dividends are considered qualified dividends and qualify for the preferential rates when they are paid by a domestic corporation or a qualified foreign corporation and the investor has met certain holding requirements.
While both qualified dividends and long term capital gains qualify for preferential rates, a significant difference between growth and dividend stocks is when the investor is taxed. Dividends are taxed as they are received while the appreciation of a stock is taxed when the stock is sold. As such, dividends tend to provide investors with a more consistent tax picture, whereas capital gains may fluctuate more with the market. However, they still provide some increased planning opportunities.
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Dividend growth investing is not for those looking for quick profits. It is a long-term strategy that seeks to invest in stable companies with consistently increasing dividends to take advantage of the power of compounding. If you choose not to reinvest dividends, they can be an additional source of income. For this reason, many retirees invest in dividend-paying stocks.
Like any investment strategy, there are risks associated with dividend growth investing, including the risk of losing your original investment. However, it can also be a valuable component of a well-balanced, diversified investment portfolio.
For more information, contact Chris Georgiou at [email protected], or call him at 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Services.