Long-Term Wealth Creation Needs Dividend Growth

When you are planning for retirement or when you are putting money away for the long term, a crucial element to consider when choosing your investments is the power of compounding, and the power of consistent dividend growth.

When you buy a stock that pays a dividend, it’s not so important that the company pays a large dividend now. In fact, a company that pays a large dividend now is probably spending too much money on dividend payouts and not enough money on expanding its business. While high dividends look enticing, you need to be careful.

However, when a dividend is low, don’t simply dismiss it as a potential income stock. Keep in mind that as a long-term investor, you shouldn’t be concerned about income today. You are concerned about income at least 10-15 years from now. So when you pick your stocks for their income potential, you need to prepare with this in mind.

The key to doing so is to pick stocks that are consistently growing their dividends significantly. Consider two scenarios. The first company pays a 4 percent yield and raises its dividend 5 percent per year. In 15 years, this company is going to roughly double its dividend payout so that the yield you will receive on your initial investment is 8 percent.

Now consider a company that pays a small — 2 percent – dividend. But assume that this company raises its dividend at 15 percent per year. It has a lot of catching up to do, but the power of compounding creates a lot of long-term value. In fact, at the end of the same 15 years, this company will be paying  eight times as much, or 16 percent on your original investment.

From these two examples, we can clearly see the power of compounding and the importance of dividend growth to long-term value creation.

The trouble is actually finding investments that will be able to grow their dividends at such a high rate for a long period of time. It is easy to look backwards and simply cherry-pick those companies that have had high dividend growth rates in the past. But such dividend growth cannot necessarily be projected into the future. In fact, some companies that have been serial dividend raisers, such as General Electric (NYSE:GE) and JP Morgan (NYSE:JPM), drastically cut their dividends during the financial crisis. With this in mind, here are a few tips for finding companies that have higher probabilities of raising their dividends every year for a long period of time.

First, look for companies that provide products that people need. Companies that make common household items (e.g., paper towels, toothbrushes, sponges, laundry detergent), companies that make commonly used food products (e.g., coffee, bread, cereal), and utility companies that provide water, gas, and power are all well positioned to consistently generate cash flow.

Second, look for companies that are well managed and that invest shareholder capital wisely. Some metrics to look at are return on equity, return on invested capital, and return on assets. Companies that outperform in these areas are better positioned to grow their businesses than their peers. Be careful, though, when looking at a metric such as return on equity, as there are some large companies out there with minimal shareholder equity, and this can skew the metric and its usefulness.

Finally, consider companies that have wide economic moats. These are companies that have businesses with very high barriers to entry. They could have brand recognition, patent protection, or large initial capital costs. These businesses are more likely to be able to sustain and grow their cash-flow streams so that they can grow their dividends long term.

Disclosure: Ben Kramer-Miller has no positions in the stocks mentioned in this article.

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