The success of the dividend growth investing strategy can be attributed to three key factors: starting dividend yield, dividend growth rate, and the reinvestment of dividends. These elements work together to create a powerful compounding effect, boosting overall returns.

It’s important to acknowledge that none of the components of dividend investing success rely directly on stock prices, which is a key benefit of this strategy.

Let’s explore each of these factors in more detail.

1. Starting Dividend Yield

The starting dividend yield is the annual dividend payment divided by the stock’s current market price. It is crucial for investors to focus on companies with an attractive starting yield. Companies with a higher initial yield can provide a strong starting point for the compounding process, making them an essential component of a successful dividend investing strategy

However, we never want to compromise on business quality so it’s important not to chase excessively high yields, as they might indicate financial distress or an unsustainable dividend. Striking a balance between an attractive starting yield and the financial health of the company is key to long-term success.

2. Dividend Growth Rate

The dividend growth rate is the rate at which a company’s dividend payments increase over time. A company with a consistently growing dividend is often seen as financially stable, with a commitment to rewarding its shareholders. The power of dividend growth cannot be understated, as even a small increase in the dividend growth rate can significantly impact the overall returns.

Investors should seek out companies with a history of consistent and sustainable dividend growth. A steady dividend growth rate not only provides an increasing income stream but also signals a company’s ability to navigate market challenges and maintain financial stability.

However, we don’t want to invest by looking only at past performance. In the following chapters we will be looking at metrics that can give us an insight into future dividend growth potential as well.

Example

Let’s consider an example to illustrate how dividend growth can increase your income over time. Suppose you invest in Company ABC, which has a history of consistently increasing its dividend payouts.

At the time of your investment, Company ABC’s stock is priced at $100 per share, and it pays an annual dividend of $4 per share, which represents a 4% dividend yield. You invest $10,000 and purchase 100 shares of Company ABC.

Year 1:

• Initial investment: $10,000
• Shares owned: 100
• Annual dividend per share: $4
• Dividend yield: 4%
• Total annual dividend income: $400 (100 shares x $4)

Now, let’s assume that Company ABC increases its dividend payout by 6% each year.

Year 2:

• Annual dividend per share: $4.24 ($4 x 1.06)
• Dividend yield(on cost): 4.24%
• Total annual dividend income: $424 (100 shares x $4.24)

Year 3:

• Annual dividend per share: $4.49 ($4.24 x 1.06)
• Dividend yield(on cost): 4.49%
• Total annual dividend income: $449 (100 shares x $4.49)

>>>

Year 10:

• Annual dividend per share: $6.76
• Dividend yield(on cost): 6.76%
• Total annual dividend income: $676

Year 20:

• Annual dividend per share: $12.1
• Dividend yield(on cost): 12.1%
• Total annual dividend income: $1,210.00

By Year 10, your annual dividend income has grown to $676, and by Year 20, it has increased to $1,210. This growth in dividend income demonstrates the power of dividend growth investing, where consistent dividend increases lead to higher income over time.

However, that’s only 1 part of the compounding process.

3. Reinvestment of Dividends

The final critical component of successful dividend investing is the reinvestment of dividends. By reinvesting dividends, investors can purchase additional shares of the dividend-paying stock, which in turn generates more dividend income. This creates a compounding effect that accelerates the growth of the investment over time.

Reinvesting dividends is particularly powerful when combined with a growing dividend, as it allows investors to accumulate more shares at an increasing rate. Many investors use dividend reinvestment plans (DRIPs) to automatically reinvest their dividends to simplify the process, but I personally prefer selective re-investment (more on that later on in the course).

Example

Let’s consider the same example as before, but now you will reinvest your dividends, and the share price grows in line with the dividend growth. Company ABC has a 4% starting dividend yield and increases its dividend payout by 6% each year.

At the time of your investment, Company ABC’s stock is priced at $100 per share, and it pays an annual dividend of $4 per share, which represents a 4% dividend yield. You invest $10,000 and purchase 100 shares of Company ABC.

Year 1:

• Initial investment: $10,000
• Shares owned: 100
• Annual dividend per share: $4
• Dividend yield: 4%
• Total annual dividend income: $400 (100 shares x $4)

Now, let’s assume that Company ABC increases its dividend payout by 6% each year, and the share price grows in line with the dividend growth. You reinvest your dividends by purchasing additional shares.

Year 2:

• Annual dividend per share: $4.24 ($4 x 1.06)
• Dividend yield(on cost): 4.4%
• Total annual dividend income: $440

Year 3:

• Annual dividend per share: $4.49 ($4.24 x 1.06)
• Dividend yield(on cost): 4.84%
• Total annual dividend income: $484

>>>

Year 10:

• Annual dividend per share: $6.76
• Dividend yield(on cost): 9.43%
• Total annual dividend income: $943

Year 20:

• Annual dividend per share: $12.1
• Dividend yield(on cost): 24.46%
• Total annual dividend income: $2446

By year 10, your annual dividend income will reach $943. By year 20, your total dividend income will have increased to $2446. This demonstrates the power of dividend growth investing with reinvestment, leading to higher income and increased share ownership over time.

It’s also important to highlight, that although dividend growth was the same in both examples – by reinvesting dividends an investors dividend income by year 20 was more than 2x higher.

Conclusion

The success of dividend investing lies in the combination of starting dividend yield, dividend growth rate, and the reinvestment of dividends. By carefully selecting stocks with attractive yields, consistent dividend growth, and reinvesting the dividends, investors can create a sustainable income stream and enjoy the benefits of compounding returns. This powerful trio enables dividend investors to build long-term wealth and achieve financial success without depending on favourable stock price movements.