The dividend growth rate (the annual rate at which a dividend paying company increases its distributions) is of crucial importance to the long term dividend growth investor.
Calculating a company's dividend growth rate is actually pretty easy.
When a company announces a quarterly dividend increase, you simply take the amount of that increase and divide it by the previous amount.
For example, suppose the XYZ Zipper Company, announced that it was increasing its quarterly dividend a penny, from $0.20/share to $0.21/share. To calculate the dividend growth rate, you take that one cent increase and divide it by the previous $0.20 payout to arrive at a 5% increase.
And if you preferred to annualize the dividend first - calculating the growth rate on a $0.80 annual dividend that now pays out $0.84 each year - you would still arrive at the same 5% increase. The quarterly method of calculation usually works just fine since most companies with stocks that pay growing dividends will raise their dividends only once per year.
That's not always the case, however, such as with certain less conventional dividend paying stocks like MLPs, REITs, Royalty Trusts, etc. A quick check on the Investor Relations section of a company's website under the category of dividend history will quickly reveal a lot about a company's dividend policy.
Dividend growth investing is a lesson in the power of compounding returns. Unlike the yield on CDs or deposits in a money market, dividends that increase every year result in an effective yield theoretically without a ceiling.
My favorite example is with McDonald's stock (MCD). Investors who purchased shares back at the beginning of 1991 and held them since (as of 2010) are now receiving just under 31% of their original investment each year in the form of regular cash dividends.
And here's something else to consider: when a dividend paying company announces a dividend increase: the press release will usually state that the increased distribution represents a certain percentage increase over the previous dividend (see our calculations above).
But for the individual dividend investor, that increase is calculated not on the current rate, but on the original rate. In our XYZ example above, suppose you were a long term owner of your shares so that when you originally invested in the company the original quarterly dividend was $.10/share.
The net result? The $.01/share increase per share may represent a 5% increase to new investors, but it represents a 10% increase to you.
So how do you calculate the future growth of a company's dividend?
Ah, if only it were that easy. But it's like any other kind of trading or investing. If you could tell the future, you could grow very wealthy very quickly.
Still, it's not all arbitrary and random either. Looking at a dividend paying company's long term historical dividend growth rate may be a pretty good indication of what you might expect in the future, especially if that growth rate has remained fairly stable and consistent on a yearly basis, and especially if the time period encompasses both economic recessionary and expansion periods.
Your analysis should also take into consideration a company's current and historical dividend payout ratio as well - if the current payout ratio is significantly higher than its historical ratio, that's an indication that future dividend expansion might not be sustainable.
I personally invest only in companies that I characterize as high quality companies. And for me, quality isn't cyclical (yes, there are many well-run companies that are also highly cyclical, but I still tend to avoid these). I prefer companies with a track record both of stability and growth.
One look at a list of Dividend Achievers (companies that have raised dividends for 10 or more consecutive years) and Dividend Aristocrats (25 or more consecutive years), and you realize just how powerful long term investing can be when you correctly identify superior businesses.
The more you study and consider dividend growth investing, the more it changes your perspective. A dividend paying stock with a current yield of 2.5% but with a long history of raising its dividends 10% a year all of a sudden doesn't look so anemic when compared to a high yielding stock with a far less stable business model.
You can't actually increase the dividend growth rate of a company, of course (unless you happen to be on the company's board). But there are a couple ways to further increase your compounded returns in conjunction with dividend growth.
The most obvious method is through the process of reinvesting dividends, or using the cash dividends you receive to acquire additional shares of stock.
An alternative approach that I personally add to the mix to compound long term returns even more is to use certain customized, conservative (and easy) option trading strategies. I call this approach, Leveraged Investing. The central idea is to use options to perpetually lower the cost basis on your long term investments.