My Financial Independence Journey » Investing » A Brief Primer on Dividend Growth Stocks Part 1: What are they and how do they make money?
A Brief Primer on Dividend Growth Stocks Part 1: What are they and how do they make money?
In the opinion of this humble blogger, dividend growth investing is a great way to build wealth over time. Dividend growth investing is a branch of value investing, that focuses on buying shares of companies with a consistent history of raising dividends. As I was putting together the initial content for this blog, it dawned on me that readers green to the idea of financial independence, dividend growth investing, or investing in general might be kind of lost by all the terms thrown around. In this primer, I presume that you know nothing and start at the very beginning.
What is a stock?
A stock is a share of ownership in a corporation. A very small share. By owning stock in a company you voting rights (you can vote for various members of the board of directors) and are entitled to a dividend payout (if the company pays dividends). Stocks are liquid and can be bought and sold major exchanges, and the price of a stock fluctuates over time according to the whims of the market. While stocks entitle you to certain benefits, you are not liable for corporate malfeasance. In other words, the company can screw up and make terrible mistakes, but you won’t be held responsible. That liability rests with the actual employees of the company.
Beginning to invest in stocks is very easy. Simply open up an account with an online brokerage company, deposit some money, and off you go.
How do stocks make money for investors?
Stocks can make money for investors in two ways, capital gains and dividends.
1. Capital Gains - Capital gains are fancy term for a stock being worth more than you bought it for. So if you buy a stock for $20 per share and then the price rises to $22 per share, you’ve made $2 per share in capital gains. That’s a 10% return. And just as there are capital gains, there are capital losses.
Capital gains only become real once you’ve sold the sock. Before that, they’re nothing but a number on paper. A number that is incredibly labile and goes up and down every day based on such factors as:
- Changes in business fundamentals - As the company becomes more profitable, the value of the company and thus the stock price should rise over time. When the fundamentals are strong, the stock price just slowly keeps on trucking upwards. There are plenty of jumps and falls along the way, but the overall trend is upwards. Of course the reverse is also true, if the company could be better run by a sack of potatoes, then the fundamentals will decline over time and drag the stock’s price with them.
- Market forces - The market is ruled by what economist John Maynard Keynes called animal spirits. Which is a very nice euphemism for short sighted speculators and computer algorithms all trying to make a quick buck or just chasing the latest fad. The market is all powerful, it can launch a worthless company into the stratosphere based on a vaguely worded press release, or crush a Blue Chip with a century of performance for missing an earnings target by a penny. Yes, despite the utter gobs of money involved, Wall Street has the overall maturity level of pack of teenage girls at a Justin Bieber concert. But these speculatory forces tend to be ephemeral, and sooner or later there’s a reckoning with the fundamentals and the stock price goes back to something more in line with the company’s business performance.
- Stock buybacks - This one takes us all the way back to Economics 101 with some simple supply and demand. As a company buys back it’s outstanding stock, the amount of shares in the market decreases. As supply decreases, assuming constant demand, the price of the stock should rise. Should the company decide to issue more shares (which can be done in order to raise additional capital), then the stock price should decline due to greater supply.
2. Dividends - A dividend is a portion of the company’s earnings paid to it’s shareholders. Dividends are usually cash, but they can also come in the form of stock or property. Dividend payouts can be one time events, or they can occur regularly. Dividends are often paid quarterly, but they don’t have to be – monthly, semiannually, or yearly dividend payments also exist.
Dividends are entirely optional (*). A company can pay or not pay. Dividends can also go up, down, or remain flat.
Unlike capital gains, cash dividends are real. You don’t have to wait to sell the stock in order to enjoy your dividends. If you own $10,000 worth of stock and you receive $350 (3.5%) in dividends, the money is yours to spend or save as you see fit. And the stock is still yours too, since you didn’t have to sell it in order to collect that dividend.
Let’s say that a company pays you $350 every year that you are a stockholder. That’s not a bad deal. You basically get a $350 return on your investment each year for doing nothing. In addition to paying a regular dividend, the stock’s price may increase over time, leading to capital gains. Many stocks that pay regular dividends are stable, profitable companies with solid fundamentals. If they weren’t, it would be very difficult for them to regularly part with wads of cash. It is common for companies paying regular dividends to see their stock prices increase over time as well. Kind of a win-win situation (regular dividends plus capital gains).
What are dividend growth stocks?
Some companies choose to grow their dividends every year. They are able to do this because their earnings steadily increase over time. Dividend growth is often a hallmark of a stable and successful company. The kind of companies that value investors like to buy. Companies with a substantial history of dividend growth are referred to as dividend growth stocks.
Dividend growth and the rate of growth are two different things. Let’s revisit our previous example of a $10,000 investment that provides a $350 (3.5%) dividend payment. If this company raises it’s dividend by 1% per year, at the end of 10 years you will receive $386.62 per year in dividends. On the other hand, if the company grows it’s dividend at a rate of 10% per year, a at the end of 10 years you will receive $907.81 per year in dividends. Either way, it’s still a dividend growth stock, but the latter example is a much better investment than the former. Growth rates are mad crazy powerful and you best respect!
Dividend growth stocks are further classified by the number of consecutive years that they have been able to grow their dividends.
- Aristocrats - Stocks that have raised dividends for at least 25 years
- Champions - Stocks that have raised dividends for at least 25 years (Same as aristocrats)
- Contenders - Stocks that have raised dividends for 10-24 years
- Challengers - Stocks that have raised dividends for 5-9 years
The Aristocrats list is maintained by Standard & Poors. The Champions, Contenders, and Challengers list is maintained by the DRiP Investing Resource Center.
Who should and shouldn’t be a dividend growth investor
Personally, I think that everyone should be a dividend growth investor. But this style may not be for you. Dividend growth investing (and value investing more generally) isn’t flashy or exciting. Dividend growth stocks are companies like McDonald’s (MCD) and Coca-Cola (KO). Tried and true, they make products that people buy every day. You won’t find flashy new companies with still to be determined business models, and without a solid history of profitability, like Zynga (ZNGA) or Facebook (FB). Given their recent performance, this might be a blessing. No fancy IPOs either. Just companies that have a consistent history of bringing home the financial bacon and sharing it through dividends. What you gain in stability, you lose in potential water-cooler banter.
Disclosure: I am long MCD and KO. See the portfolio for my current holdings.
(*) Exceptions to this rule include master limited partnerships (MLPs) and real estate investment trusts (REITs). These are unique business structures, with mandatory dividend payouts, that we’ll discuss in later posts.
Readers: Share you thoughts on dividend growth investing. What do you like about it? What don’t you like about it? Do you have another investment strategy that is working for you?
Written by myfijourney
22 Responses to "A Brief Primer on Dividend Growth Stocks Part 1: What are they and how do they make money?"
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I love me some DG stocks! Only thing I wish is that the process would go a little faster, but it’s one of the best ways to grow wealth and create another income stream.
I wish that things would move a bit faster too. But like I said, DG stocks are not exactly sexy, but they brings home the bacon. And that’s what will matter in 10 years.
I’m on board with dividend growth investing and completely agree wtih you. There are so many benefits to the strategy that I feel if more investors learned about it they would see the light and convert to a dividend growth strategy.
I wish I would have known about dividend growth investing when I first started trying to save and invest. I might not have had as much money to save back then, but it would have been nice to see how much my dividends would have grown had I started 10 years ago rather than 3 or so.
Great post! I am agree that it is a fantastic way to build wealth and create a passive stream of income. I can’t wait to see how in 10 years from now consistency over that time will really pay off!
I’ve been very pleased with my three years of progress so far. One thing that’s really great about dividend investing is that you start to realize that every dollar that you save can be turned into an income producing asset. I find that to be a very powerful mindset.
I believe you’ve hit the nail on head. Dividend growth stock investing and value investing are not sexy at all but are usually the most rewarding over time.
It’s not sexy in the beginning. But as your dividend income starts approaching your expenses, I think dividend growth investing gets a lot sexier. I’ll let you know for sure when I get there.
I experimented with a few different investing approaches till i landed on dividend growth investing, but I won’t be looking back. A couple of observations:
1) You need to give the approach some time. It will take a few years to really see your dividend machine cranking out its output for you, but once you can get it going, you will really benefit.
2) You can build solid wealth with dividend growth investing. There is a nice correlation between div increases and capital appreciation over time (in my view)
3) An early financial independence, retirement without touching your capital is very possible with this method of investing. You aren’t beholden to markets and valuations to meet your expense requirements.
Regarding #1, I think any good investment approach requires time. If your benchmark is something like buying Yahoo! during the tech bubble, I imagine that you’re guaranteed to be disappointed.
When I started dividend growth investing, I didn’t think too much about the wealth building aspects of it. I was under the illusion that dividend growth stocks grow slower than other stocks, because dividend stocks are boring. But since then I’ve come to the conclusion that dividend stocks are a great way to build wealth and will likely match or exceed index fund investing. My own investment history backs up this assertion.
Have you ever dealt with tax-loss harvesting? I’ve never had my accounts been in the red, so I haven’t dealt with it firsthand.
Yes I have actually. Back before I was a dividend growth investor, I was a no idea what I was doing investor. I had some big losses from those days. But I don’t dwell on it. I consider it a valuable learning experience.
Another wonderfully valuable post for us! We are looking seriously at investing in dividend paying stocks right now as a source of passive income. What do you think the best way to buy those is? Do you use a broker or buy on your own?
Glad you liked the article. I’ve got a whole series of introductory articles coming up over the next few months.
In my opinion the best way to buy stocks is just to open up a discount online brokerage account (Scottrade, TD Ameritrade, etc). They’re really easy to use and the commissions are very low. I wouldn’t pay for a broker (the human kind) at all. Way too expensive.
I love the comments at the top that say that they wish they’d go faster. I wish my net worth would grow faster, too, but it’s all about tradeoff….
Whenever a stock pays a dividend the chances that you’ll hit a home run diminish because you’re already getting a return on a systematic basis. I especially like these in IRA and Roth IRA accounts, so you won’t be exposed to additional taxes each year.
Dividend stocks also tend to be mature companies, so they’re not as prone to wild price run ups or crashes.
I also wish that my accounts would grow faster, that’s why I keep trying to find ways to up my savings rate. Right now, that’s the major growth engine.
Dividend growth investing is a fantastic strategy to not only build wealth, but more importantly keep it. Who wants to spend a lifetime building assets up just to sell them off to meet expenses?
I’d much rather have a big dividend tree producing cash that I use to pay my bills without having to cut off branches. In this strategy, the tree grows bigger and bigger over time to the point that it’s growing more fruit than I could ever hope to need.
Best wishes.
I always did like your tree analogy. It’s much more in line with my philosophy of wealth creation than the current model of growing a tree just to cut it down and use it for firewood. Funny thing about my investing strategy is that if I actually work a full career (no early retirement or anything like that), I’ll actually get to consider building a legacy of some kind.
This is a neat review and I will use it when teaching my kids about investing. We try to have every one day a week an evening lesson. This could be a great guideline for them and me to learn/teach. Thanks
I think it’s great that you’re teaching your kids about investing. I have a pet theory that value investing would fit perfectly in middle school. It has elements of research, math, and logical thinking all rolled into a real world situation.
[...] A Brief Primer on Dividend Growth Stocks – If your new to dividend growth investing then this article from My Financial Independence Journey is a great read. This is a good introduction starting from the very beginning of what is a stock, how do stocks make money for their owners and finishing up with dividend growth stocks specifically. [...]
[...] Part 1 of my primer on dividend growth investing was mentioned in Dividend Growth Stock Investing’s March Links. [...]