Dividend growth stocks are known to outperform the market in the long term.

Therefore, investors are always on the lookout for picking the best dividend growth stocks. It involves more than just looking at a company’s valuation and its dividend payment history.

There are many variables to consider such as the dividend payout ratio which can help to evaluate the high dividend growth stocks.

It is an open secret that dividend growth stock investing offers superior results compared to investing in stocks that do not grow dividends.

According to this research paper by reality shares, between the periods of 1992 through 2016, dividend growth stocks beat the S&P500 by 8.7%.

On the other hand, stocks with the lowest dividend growth underperformed the S&P500 by 1.7%.

Dividends were not always popular. But they returned with a bang after the dot com bubble burst. The surge for dividend growth stocks started increasing when the global economies plunged in 2008.

The chart below shows the S&P500 index dividend yields over time. You can see how dividend yields started to pick up since 2000.

With interest rates near record lows, investors searched for companies with high dividend growth. Dividends are said to be one of the constants in the world of investing. It is said that dividends contribute about a third of the stock market’s total return.

What are dividend growth stocks?

Before you start looking for high dividend growth stocks, you need to know what this means. A dividend growth stock is a company that increases the dividends paid on a semi-frequent basis.

There is no fixed definition. Some companies can raise the dividend payouts as frequently as a quarter. Other dividend growth stocks can raise dividends on a yearly basis.

The general rule of thumb is that a company which increases its dividend payouts at least once per calendar year can be a dividend growth stock. And the company should be doing this consistently for at least the past few years.

As you can see by the above definition, there are no concrete rules. There is some subjectivity involved.

Dividend growth stocks are defined into the following main categories. These are general market terms. Therefore, there are no fixed definitions for the below.

The general conception is as follows:

Challengers: Dividend challengers are stocks that have raised the dividends for the past nine years

Contenders: Stocks that raised dividends consistently for 10 – 24 years fall into the category of dividend contenders

Champions: Dividend champions are stocks that have raised dividends for more than 25 years consistently

The Aristocrats: The same criterion as Dividend Champions applies. In addition, stocks must be listed on the S&P500 in order to be called a Dividend Aristocrat.

Dividend Kings: Finally, these are companies that have raised dividends for 50 straight years.

However, do not let the past performance fool you into complacency. A good example is that of GE. In 2009, the financial crisis led to GE slashing dividends for the first time since 1938. This came as the company continued to raise dividends consistently for 32 years.

What is the dividend payout ratio?

Investors make use of different financial ratios and metrics in order to assess potential stocks for their portfolios. Among the many financial ratios available, the dividend payout ratio or DPR for short is useful when analyzing dividends.

The DPR helps to analyze the dollar amount of the dividend that a company pays in relation to the net income.

In simple terms, the dividend payout ratio shows the percentage of earnings a company paid to its investors and shareholders. Any money that is not paid out to its investors or shareholders are reinvested into the firm’s operations.

It is important to note some distinctions here. Although the dividend payout ratio offers some insight it does now provide for shareholder value. The DPR should not be used as a means to evaluate a company’s viability.

The dividend payout ratio is used when considering if you want to invest in a profitable company paying dividends versus a company with high growth potential.

You could also see this as a way to compare a steady income or reinvestment for possible future earnings.

The Dividend Payout Ratio Calculation

The DPR offers investors a way to see how much money a company puts back into growth, its cash reserves and for financing the debts. It compares these values against the amount of money that is given to the shareholders and investors as dividends.

Also known as net income, this figure can be taken directly from a company’s income statement.

The formula for calculating the dividend payout ratio is simple. You divide the yearly dividend paid by the net income.

Dividend payout ratio = Dividends/Net income

Alternately, you can also calculate the dividend payout ratio by dividing the dividends per share by the earnings per share.

Dividends Per Share / EPS

If we take an example, say a company ABC Inc. paid $1 per share in annual dividends. The earnings per share was $3. Then the dividend payout ratio would be 1/3 or 0.33 or 33 percent.

Interpreting the dividend payout ratio

Interpreting the dividend payout ratio is relative. For example, if a company as a DPR of 35%, this begs the question of whether this is a good or a bad payout. The answer to this can vary depending on how you look at it.

Typically, growing companies tend to retain most of their profits to fund growth. This eventually offers the prospects of the investor getting a more favorable dividend at a future period of time. But this comes at the cost of the investor not receiving any dividend for the moment.

On the other hand, a mature company tends to offer higher dividends. This is because there is little room for growth.

The profits are therefore diverted as dividends to make the stock look more attractive. In most cases, stocks in the utility sector fell in this category. But the trend has started to change in recent times.

Other information about a company’s strength can be derived from the DPR.

Companies pay dividends due to motivation and at levels that they think can be sustainable. Therefore, companies do not pay aggressive dividend amounts merely to please its shareholders.

When a company pays dividends at unsustainable levels, it will sooner than later have to cut back on the dividends. This can lead to a loss in share price and reflect poorly on the company’s management team.

One can also analyze the dividend payment trends over time. This can tell you if the company is able to maintain its profits and thus sustain paying the dividends.

In summary, the dividend payout ratio should be used in a context of the company and the industry it is is. The DPR can also be used to compare competitors.

How to find high dividend growth stocks?

The first place to start when looking for high dividend growth stocks is, of course, taking a look at stocks that are paying out dividends.

Start by looking at the payout ratio. A payout ratio of 30% – 50% is a good start. You can find a number of stocks under these criteria. Fundamentally, this also means that a company has ample cash left to fund its other objectives.

Secondly, looking at the balance sheet also helps. For dividend growth stocks, you should look at the credit ratings for the company as well. The strength of the balance sheet can vary over time. Companies that have large cash balance can afford to pay dividends for a while even during market turns.

A company with good investment grade ratings can have easy access to funding at lower rates. This greatly increases their ability to borrow money to bridge a gap in short-term cash flows.

Next, looking at a company’s market share and the industry growth forecasts can also help. There are two factors that enable a company to grow its dividends. A company can raise its payout ratio.

Alternately, a company can choose to increase its growth earnings.

Picking high growth dividend stocks is an art and there is a bit of subjectivity involved. Let’s take a look at a case study to understand how to pick high growth dividend stocks.

Case Study  – Lowes dividend growth

Home improvement giant, Lowes (LOWE) is a company that has an impressive dividend history. The company has been paying dividends since 1961 when it went public. Lowes is also a Dividend King because the company has been raising dividends for 54 consecutive years.

The consistent increase in dividend growth put Lowes to outperform the S&P500 index consistently over time. In the last ten years, the company gave a total return of 315%. This is a huge number when compared to the S&P500 index’s total return of just 135%.

The dividend growth was successfully met by the company as it ticked all the checks. In the past five years, Lowes has also increased its earnings per share at an annualized basis of 21%.

While most dividend companies are expected to be mature businesses, Lowes managed to continue expanding by opening new stores. The company generates $19.2 billion in free cash flow. This enables it to raise dividends as a result.

Data from 2017 shows that Lowes generated $5.1 billion in operating cash flow. Of this amount, $1.1 billion was reinvested in capital projects. This left the company with free cash flow of $3.9 billion.

In terms of ratio, Lowes currently pays less than 35% of its earnings in dividends. As a result, the dividend yield is just slightly above the average of 1.9% from the S&P500.

Excess cash flow – An indicator

While this might be low, bear in mind that the excess cash flow could lead to an increase in future dividend payouts. It also allows the company to expand its business or even to invest in shares buyback.

During 2017, Lowes bought back $3.1 billion in stock. In early January, the company announced a $5 billion share repurchase program. It is expected to repurchase a further $10 billion in shares by end of 2019.

The balance sheet of the company also has an A rating and backed with a leverage ratio within its target.

When investors look at a company such as this you can consider the cash on balance sheet. At $558 million, it is certainly not adequate to fund a year’s worth of dividends. But when you account for the cash flow and low payout ratio alongside a high credit rating, there are adequate buffers in place.

In terms of growth, Lowes has further room to grow further. According to reports, the company will be opening 10 new stores and to bring its total count to more than 2,400 locations. This, in turn, is seen to increase sales by 4%.

High dividend growth stocks – In summary

In summary, the high dividend growth stocks are known to generate a mountain of free cash flow every year. This allows them the liberty to let the money either grow their business or to pay dividends.

When looking for high dividend growth stocks, look for a dividend payout ratio between 35% – 50%. After this, the company should have spare cash flow as well so it can reinvest it back into the business.

When a company has a balanced allocation, it helps to grow earnings at an average of 10% annually. It allows for the dividend growth to rise at the same time based on the industry.

Also, note that a company should have strong buffers to provide for the necessary margins. It enables a company to grow its dividends while also being able to reinvest in more challenging times.

To be successful with investing in high growth dividend stocks, it takes due diligence. Each company and industry is different. Therefore, investors need to be very careful and allow for some flexibility.

One of the best places to start is by looking at the dividend categories mentioned earlier. You can either look at the dividend challengers or the dividend kings, both sides of the spectrum.