Investors looking to diversify their portfolio, hedge against market downturns and inflation, or potentially generate passive income may turn to dividend growth investments. The companies offering these types of stocks are often recognized as being stable, low volatility, and even having a positive future outlook. As with any investment, however, dividend growth stocks still come with risks and considerations to keep in mind.

What is a dividend?

A dividend is a portion of a company’s earnings that are paid out to shareholders. It is generally contingent on the company recognizing a surplus or profit, and is often paid on a scheduled basis, such as quarterly or annually.

These dividends may be paid in cash via a dividend check or as a credit with a brokerage of choice, or as additional shares of stock. If paid in cash, investors can reinvest it to purchase more shares or use that money elsewhere.

How does dividend growth investing work?

Dividend growth investing is a popular strategy with many investors. It entails buying shares in companies with a record of paying regular and increasing dividends. An added component is using the payouts to reinvest in the company’s shares—or shares of other companies with similar dividend track records. The goal is compound investment portfolio growth. Although dividend growth investments are generally recognized as low volatility, no investment (or dividend payment) is guaranteed.

Calculating dividend growth rate

A stock’s dividend growth rate is a percentage-based equation that tells investors how much that stock’s dividends have grown over a period of time. As a company grows, it may increase the dividends paid to investors, which may indicate stability.

The dividend growth rate is calculated by dividing a stock’s annual dividend in any given year by the previous year’s annual dividend, then subtracting 1. For instance, let’s say a company’s current annual dividend is $2.20 per share, but last year the company offered $2.05 per share. The dividend growth rate would be 7.3%.

Dividend growth rate = [Current annual dividend / previous year’s annual dividend] - 1

To find the dividend growth rate over a range of years, simply average the individual dividend growth rate change for each year in question.

Dividend growth investing strategies

A dividend growth investment strategy can focus on the following:

• Companies with a history of consistent dividend yield growth.
• Diversification in companies in a variety of industries, limiting the effect of a decline in one sector.
• Buying and holding, because reinvesting dividends is meant to compound returns over time.
• Companies whose dividend yield growth is greater than, or at least equal to, the rate of inflation.
• Companies that “earn” their dividend and make payouts from current profits, not accumulated capital or debt.
  

Each investor will have their ideal approach based on individual goals, financial situation, and risk tolerance.

Dividend yield vs. dividend growth

A stock’s dividend yield, on the other hand, can tell investors how much the company offers in dividends compared to the stock’s share price. Both yield and growth rate are important to investors for different reasons. Yield indicates how much a stock is currently paying out in dividends compared to its share price, while growth rate helps investors analyze a company’s dividend trends over time.

To calculate dividend yield, simply divide the annual dividend paid by the price of the stock.

Annual dividend yield = [dividends per share / share price]

For example, take a stock with a share price of $54.50, which offered a dividend of $2.20 per share last year. In this case, the annual dividend yield would be 4.04%.

How to invest in dividend growth stocks

Finding dividend growth stocks may involve analyzing stable companies with a history of growth, as well as calculating (or finding) their dividend growth rate.

The Dividend Aristocrats Index, which tracks companies that have offered increasing dividends for the last 25 consecutive years, is a helpful resource for reviewing dividend-paying stocks with a potential for growth. According to the index, the companies therein have proven they can successfully navigate real estate bubbles, economic downturns, recessions, financial crises, volatility, and even pandemics without breaking stride.

Risks of dividend growth investing

Of course, no investment strategy is without risk, and this includes dividend growth investing.

• Nothing is guaranteed.

  There is nothing to say that dividends won’t be cut in the future or that stock prices won’t fall. If investors have chosen to reinvest dividends and purchase additional shares, rather than putting that passive income to work elsewhere, the impacts of an unexpected and drastic drop in share price could be amplified.‍

• Dividend growth investments are long-term investments.

  For investors looking to recognize significant growth in a short period of time, dividend growth stocks may not be the right fit. Dividend growth investments are generally popular among long-term investors.

The bottom line

Dividend growth investing is inherently a long-term investment strategy. It takes time to work, because the goal is consistency, not quick profits. The added benefit of reinvesting dividends also takes time to yield results. Of course, dividend growth investing isn’t risk-free: Companies with long records of consistently rising dividends can run into trouble and cut their payouts.