After finding potential equities with above-average yields and good dividend histories as described in my last two articles, the next logical step is to look at the rate of dividend growth. We will need to determine whether the dividend growth rate has been constant, accelerating or slowing. Just like there are multiple ways to evaluate the general dividend history, there are multiple approaches to evaluating the dividend growth rate. In this article I will present one of the methods that I have found to be relatively easy and quick.
First, download the dividend history data from your website of choice into a table. I have described briefly in my previous article my favorite method to download the information from Yahoo Finance. Once you have the data in Excel — or any other spreadsheet application that you use — I suggest that you copy the data onto a blank sheet, so that you can manipulate the data and retain the original dataset in case you need it to run a different analysis.
Next, you need to calculate the total annual dividend for each year. Some websites provide the sum of total annual dividends and in that case, you will just skip the summarizing part and skip to calculating the annual growth rate. In most cases, the dividends will be distributed quarterly, so you will need to add the four quarterly dividend distributions to get the total annual dividend amount. You can use any layout that you prefer.
Calculating growth rates
After calculating the total annual dividend payout for each year, you have to calculate the annual growth rate versus the prior year. To do this, deduct from one year’s total annual dividend amount the total annual dividend from the previous year and divide that difference by the prior year’s total dividend.
This is the percentage dividend growth rate. Do this calculation for at least the last five years — 10-15 years is better.
For example, the total annual dividend for 2018 is $2.10 and the total annual dividend for 2017 is $2.00 in the table below. Therefore, the dividend growth rate for 2018 is 5%.
($2.10 – $2.00) / $2.00 = 0.05 * 100 = 5%
Below is an example using the dividends that were paid out by Johnson & Johnson between 2009 and 2018.
Please note that you will not be able to calculate the growth rate for the earliest year in your data set, because you do not have the previous year’s data for the calculation. In the table above, the growth rate for 2006 is not calculated because the 2005 data is not included. Also, I have rearranged the table into two separate columns for easier display within this article.
This table gives an overview of dividend growth rates over the past 10 years. To get an even better picture, you could create a chart like the two examples below. Although creating the chart takes a bit of time and effort, looking at a graphical representation of the data makes it easier to analyze the progression of annual dividend growth rates.
It is clear from the table and the charts above that HCP has had its good years and its not-so-good years. This dividend growth history looks similar for other health care Real Estate Investment Trusts (REITs), since this industry is growing slowly despite the growing demand for services. This is likely partially due to the economic, business and political efforts that are underway to control health care costs and is also partially the nature of this industry. However, the most positive conclusion from HCP’s dividend growth history is that the dividend continued to grow — even during the severe economic recession that started in 2008. This is ALWAYS a positive sign for an income stock.
The ideal income security will show consistent dividend growth, year after year. Clearly, the growth rate of most income securities will decline during economic contractions. Conversely, most reliable income securities will grow their dividends more quickly during economic expansions.
When reviewing a stock’s dividend history and its growth rate, the first danger sign is a dividend cut. Some income investors will not consider any stock that has issued a dividend cut in its history. However, I agree with other investors who will not necessarily eliminate a stock from consideration because of a single dividend cut in its past. Instead, I will look at the conditions under which the cut occurred and why. I will also look to see whether the same management is still managing the company or if the management team been replaced since the dividend cut. However, any company with a past dividend cut warrants special review of its coverage ratios — which I will discuss in another article — and the other market conditions that are affecting the company.
The second danger sign appears when dividends are growing too quickly. Yes, I mean too quickly. A dividend that is growing too fast suggests that the company is engaged in some business activity that is producing a growth rate which is not sustainable. The market will typically reward such a stock with a higher price and lower yield. This combination might be enticing to an income investor who is willing to take a lower yield for stronger dividend growth, as the total of dividends that can be collected over the years ahead may project out to be greater than a similar higher yielding and lower dividend growth stock. However, if the dividend growth rate slows, which it usually does at some point, the total amount of dividends that will be collected over subsequent years will be reduced. Now, the income investor may wind up with a a low yield, moderate dividend growth stock.
To recognize such a stock, compare its dividend growth rate with its peers. If stock X is a pharmaceutical stock whose two-year dividend growth is 18% per year and five other pharmaceutical stocks show a dividend growth rate of 7% over the same two years, stock X will almost certainly slow its growth at some future point.
Another potential pitfall in a high dividend growth rate is a special dividend, which a company may make once or twice, often when the company sells some of its assets and returns the proceeds to its shareholders instead of reinvesting them. Since this type of earnings distribution to shareholders through dividends could leave the company with insufficient funds to support operations or expansion, it eventually becomes unsustainable.
The third danger sign is a dividend whose growth is gradually slowing or has stopped. This suggests that the products or services of the company are maturing, the company management is not providing adequate returns on its business investments, competition is driving down revenues, and so on. Under such circumstances, the company needs to look for new investments and business lines to support future revenue and dividend growth.
Revenue growth in the pharmaceutical industry generally depends on the drug company’s ability to have new drugs ‘in the pipeline’ for testing and marketing. The inability to do this does not bode well for a pharmaceutical company’s ability to grow its future dividends. The kind of dividend history shown above by Eli Lilly & Co (NYSE:LLY) would be of major concern to me — regardless of the reason.
The ideal company for our portfolio has never cut its dividend and has a long, consistent dividend growth rate that is sustainable. Perhaps most importantly, the company must demonstrate its ability to grow its dividends even during down markets. Ideally, the potential security will grow its annual dividends consistently between 3 to 5% per year for at least 10 years.
While very important, the dividend growth rate is just one of the selection factors that investors must consider when picking a dividend income equity. In my next article, I will discuss the nature of the company’s business. As a selection factor that is conducive to more subjective evaluation — like the company’s dividend history — the nature of the business requires some insight that investors can only gain through experience. However, I will provide some general guidelines to try to make the process as simple and as straightforward as possible.
Bruce Miller is a certified financial planner (CFP) who also is the author of Retirement Investing for INCOME ONLY: How to invest for reliable income in Retirement ONLY from Dividends and IRA Quick Reference Guide.