What is a Good Dividend Growth Rate?

Before diving into specific numbers, let's start with the big question: what is a good dividend growth rate? The answer depends largely on the type of investor you are and the industry in question. However, as a general guideline, many experts consider a 5-10% annual growth in dividends to be solid. Why? A steady growth rate in this range shows that the company is increasing its earnings and has a sound business strategy. Anything less than 5% might indicate that the company is not reinvesting or growing enough to boost future payouts. On the other hand, a growth rate above 10% could either be a sign of a rapidly expanding company or, on the downside, a company that may struggle to sustain such high growth rates over the long term.

The Art of Dividend Growth Investing

Dividend growth investors are a particular breed. They're not just looking for the highest immediate yield; they’re looking for companies that can sustainably grow their dividends over the years. This approach requires discipline and a long-term outlook. The ideal investment target in dividend growth investing is a company that not only pays dividends regularly but also increases those dividends year after year. Why is this important? Because inflation erodes the purchasing power of cash over time. A steadily growing dividend helps to maintain the real value of your investment income.

How Do Companies Decide on Dividend Growth?

Companies with steady cash flow, strong market positions, and robust earnings growth tend to offer healthy dividend increases. But it’s more than just a boardroom decision. The company’s leadership must balance returning profits to shareholders with reinvesting in the business for future growth. To do this, they evaluate several key metrics like payout ratio, free cash flow, and earnings growth projections.

• Payout Ratio: This is the percentage of a company’s earnings that it returns to shareholders in the form of dividends. A payout ratio between 40% and 60% is considered healthy. Anything over 70% can be risky, as the company is retaining little for reinvestment.

• Free Cash Flow (FCF): This is the cash available after a company covers its capital expenditures. Companies with strong FCF can afford to increase dividends.

• Earnings Growth: If a company's earnings are growing at a steady rate, the board of directors may be more inclined to boost dividend payments to share that success with investors.

The Importance of Compound Growth

Compounding dividends are what make dividend growth investing so attractive. Imagine you have a company growing its dividend by 7% per year. Over 10 years, this can lead to a substantial increase in income. Not only are you receiving the initial dividends, but the growth compounds, meaning next year’s dividend is based on this year’s higher payment. This effect becomes even more dramatic if you reinvest the dividends.

Here's a simple table showing how dividend growth compounds over time:

Year	Initial Investment	Dividend Growth Rate	Dividend Income	Total Value with Reinvestment
1	$10,000	7%	$300	$10,300
5	$10,300	7%	$393	$11,850
10	$11,850	7%	$556	$14,150

This table illustrates how the power of compound growth can lead to significant income gains over time, even with a moderate growth rate of 7%.

Case Study: Coca-Cola and Procter & Gamble

Two of the most famous dividend growth stocks are Coca-Cola and Procter & Gamble. Both of these companies have been raising their dividends for decades. Coca-Cola, for example, has had an average dividend growth rate of about 6% annually over the past 10 years. Procter & Gamble is slightly more conservative with a growth rate around 5-6% per year. These companies are stable, operate in defensive sectors, and offer investors reliable dividend growth.

Sustainability: When Dividend Growth Goes Wrong

Dividend growth can be attractive, but sometimes it’s not sustainable. Take General Electric as an example. For many years, GE was a dividend aristocrat—a company known for increasing its dividends annually for at least 25 consecutive years. However, the company overleveraged itself, and in 2018, GE had to slash its dividend dramatically. This shows that even if a company has a long track record of dividend growth, investors must always be vigilant. Excessive debt, shrinking profits, or economic downturns can derail even the best-laid dividend plans.

Current Trends in Dividend Growth

As of 2024, the global economic environment is characterized by rising interest rates and inflationary pressures. Many companies are feeling the squeeze, and some are pausing or reducing dividend growth rates. However, certain sectors, such as technology and healthcare, are still providing investors with robust dividend increases. For example, Apple has been steadily increasing its dividend payout, though its yield remains relatively low compared to more traditional dividend stocks.

In contrast, energy companies like ExxonMobil are currently benefiting from higher oil prices and are rewarding shareholders with increased dividends. As the market adapts to these economic shifts, dividend growth investors must be selective about where they put their money. Defensive sectors like utilities and consumer staples often provide safer, more stable growth, while cyclical sectors can offer higher but riskier dividend increases.

Balancing Yield vs. Growth

It's easy to be tempted by companies offering high dividend yields, but yield alone doesn’t tell the whole story. For example, a company with a 10% dividend yield but no growth is far less appealing than one with a 3% yield that grows at 8% per year. The latter will eventually provide higher income and better capital appreciation, as the dividend growth compounding takes effect.

Let’s compare a high-yield, low-growth stock versus a low-yield, high-growth stock over 20 years:

Stock Type	Initial Yield	Dividend Growth Rate	Income Year 1	Income Year 20
High-Yield, Low-Growth	8%	1%	$800	$982
Low-Yield, High-Growth	3%	8%	$300	$1,348

The low-yield stock ultimately offers more income over time, demonstrating the power of dividend growth.

Conclusion

Ultimately, a good dividend growth rate lies in the balance between a company’s ability to consistently increase dividends while maintaining financial health. Investors should aim for companies with growth rates in the 5-10% range, strong free cash flow, a healthy payout ratio, and solid earnings growth. Over time, these factors contribute to sustainable income growth that can weather economic cycles.

For dividend growth investors, the most important principle is patience. Compound growth works its magic over the long haul, and those willing to stay the course will find themselves richly rewarded.