Continuing on with the theme of what I look for when picking a stock, we turn to a factor closely related to the earnings growth rate, dividend growth rate. As I said during the post on earnings growth, the fair value of a stock is based in part on the return people expect to get from the stock relative to what they can get from the bank, bonds, and other sources. While people will buy stocks early on expecting to make most of their profits from capital gains (when the stock goes up in price and they sell the shares), as a stock matures and stops growing rapidly investors who are looking for a steady return will start buying the stock. They will buy primarily based on the dividend rate.
Because people will be willing to pay more for the stock if the dividend is higher than what they can get from other investments of equal risk, a stock will tend to go up if the dividend is increasing. If it is increasing very rapidly, because earnings are increasing rapidly, people may actually bid the price up to the point where the yield drops below equilibrium because they are buying the stock based on future dividends, not current dividends. The price of the stock will also go up if interest rates are falling (because bank interest rates will also be falling), and vice-versa. The rate of taxes on dividends relative to those on capital gains will also have an effect. If the Bush tax cuts expire as is expected and dividend tax rates return to 20%. more investors will start buying stocks with small dividends, opting instead for price appreciation, so that they can delay paying taxes.
I therefore look for stocks that have a steady dividend growth rate of at least 10%, if the stock is fairly mature, since I can then expect to get both a good dividend and a growth in price of at least 10% over the long-term. Care must be taken to ensure that earnings are also growing at a steady rate or the company won’t be able to continue to raise the dividend.
Also note that even if the dividend seems small now – say 1% – as the stock grows and continues to increase its dividend, the effective yield you will receive based on the amount invested will grow. This is another reason to hold stocks long-term. For example, let’s say you but a stock for $10 that pays a $0.10 dividend – for a yield of 1%. If that stock continues to grow and doubles its dividend every four years, assuming the price to dividend ratio remained the same, the stock would be paying $0.40 in eight years and have a price of $40. While the yield would still only be 1% on the value of the stock based on the current price, because you bought in at 10% you would be receiving a 4% return each year on your money.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.