ETF Rotation Strategy

The Value of Dividend Growth Investing

Dividend growth investing is a great investment strategy if you seek for a steady stream of income on a regular basis. By constructing a well-diversified portfolio of dividend-paying stocks, you can basically start living off dividends, provided that you focus on the dividend payout, instead of the dividend yield.

How Dividend Growth Investing Works

Dividend growth investing allows you to take advantage of a bear market and compound your returns. Assuming that you have 100 shares of a stock that currently trades at $25 and pays a dividend of $3.00 per share. This means that you will get $300 in dividend payments. If the stock price goes down to $20, you can buy 10 additional shares for $200 and have a total of 110 shares. So, in the next dividend payment, you will get $3.00 x 110 shares = $330, instead of $300. When the market price recovers to $25 or higher, you will realize a higher return on the total number of shares you have purchased during the bear market and you can calculate your portfolio growth on a higher number of shares. In doing so, you also hedge the inflation risk.

The 25x Rule

The 25x rule is pretty popular among dividend growth investors as it denotes how many times of your annual income you should invest in dividends if you want to get a portfolio return of at least 4% or higher. The theory behind the 25x rule is an annualized rate of return 4%, known as the safe withdrawal rate rule-of-thumb. This is because, most of the times, retirees withdraw no more than 4% of their retirement income in year 1, while following the rate of inflation in the subsequent years.

Assuming that you want to withdraw $40,000 from your retirement portfolio. Based on the 25x rule, you need to invest $40,000 x 25 = $1,000,000. Until the age of 55, you keep on withdrawing 4%. At the age of 56, you start withdrawing your money considering an inflation rate of 3%. So, you get $40,000 x (1+3%) = $41,200 and so on.

Here is how your portfolio will look like after 15 years (at the age of 70):

After 15 year, your retirement portfolio has grown by 55.8%.

How to Select Dividend-Paying Stocks

Not all stocks are paying dividends, and not all dividend-paying stocks can offer you the same returns. Most investors follow key valuation metrics, such as P/E, P/BV, P/CF, EV/EBITDA and more in order to get a better idea of the company size and value. Dividends are also a great indicator of firm value as even smaller dividend-paying companies may have a sustained growth potential.

Assuming that you hold 1,000 shares of a dividend-paying stock that is currently trading at $75.12 and is expected to grow by 5% in the coming quarters. The company pays an annualized dividend of $3.00 per share, and you need to know the present value of the annualized dividend in order to check if the stock is undervalued or overvalued. Value investors typically look for undervalued stocks that have room for growth so that they realized long-term returns when the stock price rises to the intrinsic value of the share.

Thus, if the intrinsic value of the stock is lower than $75.12, the stock is overvalued, which means that it trades higher than its true value. Conversely, if the intrinsic value of the stock is higher than $75.12, the stock is undervalued, which means that it trades lower than its true value. Undervalued stocks are a great signal for buying opportunities.

Dividend Reinvestment Plans and Value Investing

A dividend reinvestment plan (DRIP) allows you to reinvest your cash dividends by compounding your returns. For example, you own 1,000 shares of a stock that currently trade at $75,12. The company declares an annualized dividend of $3.00 per share, and you receive $0.75 per share, totaling to $750 per quarter for all your shares. By enrolling in a dividend reinvestment plan, you are giving up those $750 on the dividend payment date, and you buy $750/75.12 = 9.98 new shares. The new total number of shares is 1,009.98.

In the second quarter, you $0.75 per share, totaling to $757.49, which you forfeit, and on the dividend payment date you buy $757.49/$75.12 = 10.08 new shares. The new total number of shares is 1020.07.

Here’s what your investment portfolio will look like in Year 1:

 By the end of Year 1, you own 1,040.54 shares.

Assuming that the stock price drops by 2%, down to $73.62. Automatically, with the same annualized dividend of $3.00 per share, you have more money available to reinvest in the DRIP. In fact, you can reinvest 1040,54 x 0.75 = $780.40, which you forfeit for purchasing $780.40/$73.62 = 10.6 new shares.

Here’s what your investment portfolio will look like in Year 2:

By the end of Year 2, you own 1,083.59 shares.

Assuming that the company declares a 12% dividend increase, up to $3.36. This means that you get a quarterly dividend of $0.84 per share, and you can reinvest 1,083.59 x $0.84 = $910.22. On the dividend payment date, you forfeit $910.22 to buy $910.22/$73.62 = 12.36 new shares.

Here’s what your investment portfolio will look like in Year 3:

By the end of Year 3, you own 1,133.90 shares.

So, within 3 years, you have increased the total number of shares by 13.4%. By owing more shares, you are more likely to get a higher return on investment, depending on how the stock market moves.

Also, keep in mind that the new shares do not incur any commission and that DRIPs are allowed for at least $10.