Dividend growth investing

In short

You have probably heard someone say a stock paid them money just for holding it. That is exactly what we are talking about here. A company shares a slice of its profit with you, the owner, on a regular schedule. Some companies have raised that payment every single year for decades. That pattern is what dividend growth investing is built on. You do not need to sell anything to collect it.

The whole of it

What it is

A friend of mine once said owning a dividend growth stock feels like renting out a small piece of a business. You hold the stock. The company sends you cash. Then it sends you a little more cash next year. The word dividend just means a payment a company makes to its shareholders, meaning the people who own its stock. The word growth in this context means the payment goes up over time, not just stays flat. Investors who follow this approach look for companies with a long record of raising that payment year after year. They are betting that a company willing to raise its dividend consistently is probably a well run company. That is the core idea. Nothing fancy.

How it works

I once watched a neighbor plant an apple tree. He did not eat apples that first fall. He waited, and the tree grew, and eventually it gave him more apples than he could handle. Dividend growth investing works on a similar kind of patience. You buy shares of a company. The company pays a dividend, usually four times a year. You can take that cash and spend it, or you can use it to buy more shares. Buying more shares with your dividends is called reinvesting. When you reinvest, next quarter you own a few more shares, so your next dividend payment is a little bigger. That process is called compounding. Compounding means your money earns more money, which then earns even more money. Over many years, the effect can be large.

The key variable beyond compounding is the growth rate of the dividend itself. A company that raises its payment by a few percent each year is fighting inflation for you. Inflation means prices rise over time, so a dollar buys less. A rising dividend can keep pace with that. Some investors track a group called the Dividend Aristocrats, which is a name Standard and Poors uses for companies in its index that have raised their dividend every year for at least the current figure, which the official source publishes each year consecutive years. The official list lives on the S and P Global website. Another group, called Dividend Kings, is tracked by various financial publishers and generally means companies with the current figure, which the official source publishes each year or more consecutive years of increases, though that term has no single official keeper.

The numbers, and where to find yours

If you are holding a stock and wondering what it actually pays, the number to look at is called the dividend yield. Yield is the annual dividend divided by the current share price, shown as a percent. A stock trading at 40 dollars that pays 2 dollars per year has a yield of 5 percent. Simple math. Some investors also track what is called yield on cost, which uses the price they personally paid rather than today's price. That can be an interesting measure over time. But the standard yield figure you see quoted uses the current market price, not your original purchase price. Do not mix the two up.

Yield alone can fool you. A very high yield sometimes means the stock price dropped sharply, which can signal trouble. That is called a yield trap. The payout ratio is another number worth finding. It shows what portion of a company's earnings it pays out as a dividend. A company earning 4 dollars per share and paying 2 dollars per share has a payout ratio of 50 percent. A very high payout ratio, say above 80 or 90 percent, may mean the company has little room to keep raising the dividend if earnings dip.

You can find dividend history for individual stocks on the investor relations page of the company's own website. The SEC's EDGAR database at sec.gov holds company filings where dividend declarations appear. For tax purposes, dividends are classified as either qualified or ordinary. Qualified dividends are taxed at lower capital gains rates. Ordinary dividends are taxed as regular income. The IRS explains this distinction on its official page for Publication 550 at irs.gov. Your broker's year end tax form, called a 1099 DIV, will tell you which category your dividends fell into.

A worked example

Meet Clara. She is 38 years old and works as a school librarian. Clara buys 100 shares of a fictional company at 50 dollars per share, so she spends 5000 dollars. The company pays an annual dividend of 2 dollars per share. Clara collects 200 dollars in dividends her first year. She reinvests every dollar. The company raises its dividend by 6 percent the next year, so the payment becomes 2 dollars and 12 cents per share. But Clara now owns slightly more than 100 shares because she reinvested. Her income goes up from two directions at once: more shares and a higher payment per share.

After 10 years of this, without adding a single new dollar, Clara's annual dividend income has grown noticeably. She has not sold a single share. She has not tried to time the market. She simply let the math work. Clara also checks the payout ratio each year when the company reports earnings. If it climbs too high, she pays attention. That is the discipline this approach requires.

Where it goes wrong

I once read about a man who bought a high yield stock without reading a single page of the company's financials. Watch out. The most common mistake is chasing yield. You see a 9 percent yield and it looks wonderful. But if the company cannot sustain its earnings, it will cut the dividend. A dividend cut usually sends the stock price down too. You lose on both fronts. That hurts.

Another thing that trips people up is ignoring taxes. If you hold dividend stocks in a regular brokerage account, you owe taxes on dividends each year, even if you reinvest them. Holding dividend stocks inside a tax advantaged account like a traditional IRA or a Roth IRA can change that math. Contribution limits and rules for those accounts are set by the IRS each year and listed on irs.gov. Concentration is a quieter danger. Owning five stocks in the same industry means a single rough patch in that industry can damage your income across the board. Diversification, meaning spreading your money across different kinds of businesses, matters here just as it does anywhere else. And one more thing: dividend growth investing takes time. It is not built for someone who needs money next month.

Questions to answer before you leave this page

Before you close this page, it is worth sitting with a few honest questions, and I mean asking them quietly to yourself rather than rushing past them. Do you understand the payout ratio of any company you are considering, and does it leave room for the dividend to keep growing if the company has a slow year? Have you looked at whether the dividend has actually grown each year for a meaningful stretch of time, or does it just look attractive right now at this price? Do you understand the difference between the standard yield based on today's price and your own personal yield on cost, and do you know which one you are looking at? Are you holding these investments in the right kind of account for your tax situation, and have you checked the current contribution limits on irs.gov for whatever account type fits you? Do you have enough variety across different kinds of businesses so that one bad season in one industry does not take down your income all at once? And perhaps the most important question of all: are you genuinely willing to wait, not months but years, for this approach to do what it is designed to do, because patience is not optional here, it is the whole thing?