Whilst high-yield shares have been receiving most of the attention in this low interest rate environment, dividend growth shares should also be considered for any income-based portfolio designed to stand the test of time.
Investors wanting to maximise current income may feel content with a portfolio built solely with high-yield shares. But because today’s higher-yielding shares are also likely to be in the slower growth stage of their life-cycles, it’s important to also consider which shares might provide inflation-beating dividend growth in future years.
And that’s where dividend growth shares can play an important role.
That said, dividends that might be paid to us five-to-ten years from now are much less assured than the dividends we’re going to receive next year, so knowing how to make conservative growth forecasts is critical to dividend growth success.
As with high yield share research, healthy balance sheets and free cash flow cover remain important, so as you research dividend growth shares, keep those important factors in mind.
Today though we’ll focus on measuring dividend growth potential. Once we’ve estimated a company’s sustainable growth rate, we can better gauge the opportunities we’re presented and weigh them against alternative investment choices.
History may rhyme, but it doesn’t repeat
The first place many investors look when determining dividend growth rate potential is the dividend track record. But whilst momentum may play a role in future dividend growth – few companies growing their payouts at 15% per annum suddenly flatline the next year – it’s dangerous to presume that past is prologue.
In other words, don’t use the past five-year growth rate as your five-year forecast.
Instead, use dividend history to understand what has been driving the growth rate. Was it due to an expanding payout ratio, for instance, or was it completely due to earnings growth?
A firm that’s been driving dividend growth by paying out a greater percentage of its earnings will not likely be able to repeat that performance. You should adjust your forecast accordingly.
Focusing on the fundamentals
Rather than look just at dividend history to determine future growth potential, we can use the financial statements to calculate a sustainable growth rate (SGR) – that is, the maximum growth rate the company can sustain without increasing its financial leverage:
SGR = (1 – payout ratio) x return on equity
Where:
Payout ratio = dividends per share/earnings per share
Return on equity (ROE) = net income / shareholder equity
To illustrate, let’s assume a share is paying out £1 in dividends for every £3 in earnings (a payout ratio of 33%) and has a return on equity of 15%.
SGR = (1 – 33%) x 15%
SGR = 10%
This SGR calculation assumes that the company takes the £2 in earnings that it isn’t paying out in dividends and reinvests in the business at a 15% return. Assuming the company’s payout ratio and ROE doesn’t change much in the next five years, then, it’s reasonable to assume that the company’s five-year dividend growth rate should approximate 10%.
To see how the SGR can change based on ROE and payout ratio, you might consider the following table:
| ROE | Payout Ratio | SGR | £1 of earnings in 5 years |
| 15% | 100% | 0.0% | £1.00 |
| 15% | 75% | 3.8% | £1.20 |
| 15% | 50% | 7.5% | £1.44 |
| 15% | 25% | 11.3% | £1.70 |
| 15% | 0% | 15% | £2.01 |
Note: SGR is rounded to one decimal place
Ah, but if it were only so simple!
Payout ratios and ROEs can change year-to-year, especially with cyclical companies. It’s extremely risky, for instance, to use the most recent payout and ROE figures for a commodity company in a peak year. You’ll come out with a very low payout ratio and a very high ROE, and thus an unrealistic SGR.
A workaround to this is to use a normalised payout ratio and ROE assumption by taking the averages over the most recent business cycle of 5-to-7 years. Even if you normalise the figures, however, the SGR results may still not make practical sense.
For example, let’s assume a large-cap company with an ROE near 30%. We’ll also assume £1 dividends per share and £2 earnings per share for dividend cover of two times (a 50% payout ratio). The share is also trading with a 3% yield and carries a £33 per share price.
If we used those figures to determine SGR, we would get:
SGR = (1 – 50%) x 30%
SGR = 15%
A 3% yield plus potential for 15% annualised dividend growth is a very attractive proposition, but it’s probably too good to be true. Large-cap shares with this type of dividend growth potential simply don’t escape the notice of institutional investors.
Buybacks and dividend growth
Large companies generally are not able to reinvest the majority of their earnings back into the business to earn 30%-plus returns. As the company gets bigger, the absolute amount of high-return opportunities doesn’t usually keep pace.
This is why more mature companies usually engage in dividend and buyback programmes and engage in more acquisition activity – they need something to do with their excess cash.
To illustrate, let’s assume the company can reinvest 20% of its earnings (£0.40 per share) at the 30% return on equity. This implies a more earthly 6% sustainable growth rate in earnings and leaves £1.60 per share remaining for dividends and buybacks.
In a perfect world, this company might pay out all £1.60 per share in dividends, resulting in a 4.8% dividend yield. In today’s markets, however, buybacks are frequently employed alongside dividends, so we’ll assume the company is using the remaining £0.60 per share (£2 EPS – £0.40 reinvested – £1.00 dividends) for buybacks.
Knowing that the company is trading for about £33 per share, we can see that £0.60 per share going to buybacks should eliminate approximately 1.8% of shares outstanding (£0.60/£33). We can then add this 1.8% to the 6% adjusted SGR result and estimate that earnings can grow at 7.8% and provide underlying support to dividend growth.
This isn’t to say that the buybacks will necessarily enhance shareholder value in any way – only that they can support dividend growth by reducing the number of shares the company needs to pay dividends to in a given period.
Don’t be afraid to forecast
As you can likely surmise by this point, forecasting dividend growth is not an exact science. If it were, we active stock pickers could all set up complex equations to automate our investment decisions and build our dividend portfolios, and turn our attention elsewhere.
Some market watchers may therefore see forecasting as a futile task, but when you purchase any share you are nevertheless making an implicit assumption about future growth – that is, the growth that’s currently assumed in the share price. I’d much rather explicitly state my underlying assumptions and hold myself accountable than make like an ostrich.
Forecasting growth is a probabilistic task. Your original assumptions may be a good baseline, but also consider alternative scenarios and see how they might affect your interest in the share.
Finally, you can be more confident with your forecasts, all else being equal, the stronger the firm’s competitive advantages. In contrast if the company is engaged in selling commodity products and has no clear advantage over competitors, it’s important to consider a wider range of possible outcomes and demand a larger margin of safety before purchasing the share.
Read all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.
Comments on this entry are closed.
Some excellent food for thought. Having come from a base of traditional passive index investing I’m seeing more and more discussion and focus on dividend income investing coming to the fore front. I’ve been researching the differences quite a bit recently and your articles have been very helpful in weighing up the two sides. Keep ’em coming.
New author? Welcome and thanks for putting together a structured article showing how those levers work.
It’s a fairly bold assumption to imagine that the n+1th pound will be invested with the same average return as the previous n. I’d assume there were diminishing returns. There usually are. So you might be incrementing at half the RoE or, managers being what they are, worse.
I like dividends, partly because they remind those agents who is the principle, but mostly because they grease the wheels of reallocation and have interesting tax implications. Otherwise, RoE would appear to be more important that the window-dressing of how you split it between Income and Capital gain.
@Mathmo — Morning! The Analyst, a friend of mine, has written about a dozen articles, which you can access via the link at the bottom of the piece. He’s been on a bit of a hiatus and I don’t know if I can get him back regularly, unfortunately. 🙁
Dividend growth investing is certainly more sexy than the passive approach and I must confess that I do hold some individual shares just for the dividends. However for the man the street, passive is still the way to go.
This is a useful post for those who are willing to put the time and effort in, and are confident enough to risk their cash on their abilities as a stock picker.
@MyRichFuture — Yes, this is certainly not a call to switch from Passive to Active (or even to debate the merits really). 🙂
We have a bit of a snag with the site at the moment, which is that our passive maven The Accumulator is offline quite a bit working on this book of ours with the slender hours he has spare for Monevator action, which in turn means the old “Tuesday Passive / Thursday Active / Saturday Free-for-All” schedule has broken down a little.
Hopefully people will do their best to remember Monevator has always been a multifarious sort of site. 🙂
@The Investor – It’s always nice to read different approaches to investing and differing points of view on this site. People should educate themselves on various approaches so they can make informed decisions. This helps them do that, so I’m all for it.
Very interesting piece, thanks.
On the same theme, I attended an excellent investment seminar from Schroders – a highly reputable fund manager – this week. Their ‘income fund’ guy also talked about ‘dividend cutters’ being a useful place to look for future dividend growth.
His argument being that companies don’t like cutting dividends but when they do – or often just before they do – you’ll see:
a) A dramatic fall in the share price and
b) A change of management that’ll change the company’s prospects from that point.
According to his data – on average dividend cutters generate higher dividend growth after the cut. No surprise there I guess – and he was at pains to point out that they do NOT select shares purely on one factor alone.
From my perspective – gaining insights into the strategies of good ‘stock picking’ fund houses (for income or growth) is interesting but it leads me back to the same conclusion.
It’s generally worth paying a small % for solid fund and risk management.
Interesting article, buy I agree with @mathmo – I’d also assume diminishing returns unless it were a rather small company who have more capacity and less overheads to keep propelling themselves along the higher growth pathway.
Notice the subtle use of ROE rather than ROCE.
Both the Analyst and ourselves seem to have fallen foul in the case of Tesco, by not using ROCE, where the margin between return on debt and the cost of debt was on a down trend.
Terry Smith had picked up this warning sign and had taken avoiding action.
Wish we had been so prescient.