In my studies of dividend stocks, I have uncovered three stages of dividend growth. These stages include initial growth, mature growth and decline. Understanding at what stage your income producing security falls in could be indicative of whether you make money with dividend paying stocks or you lose your shirt.
The initial stage is when a company has finally initiated a dividend policy. The first dividend payments are rather low in proportion to earnings, which typically leads to small yields in the beginning. The small amount of dividends however create the potential for companies to keep raising them at above average rates of growth until a sustainable peak in the dividend payout ratio is reached. The rates of dividend hikes would typically be above the growth in earnings, particularly if the dividend payout ratio is low.
For example, when Microsoft (NASDAQ:MSFT) started paying a dividend in 2003, it paid an annual dividend of 8 cents per share. In comparison, earnings per share for 2003 were 93 cents. The yield at the time was 0.30%. Fast forward to 2013, and the company is paying an annual dividend of 92 cents per share, and yields 3.30%. Microsoft is expected to earn $3.04 per share in 2013, and therefore could afford to raise distributions at a double digit rate for the next decade.
After a company has initiated its dividend policy, and has paid distributions for several years, there comes a time when it reaches its target dividend payout ratio. At this moment going forward, the rise in company’s distributions is limited by its ability to grow earnings. Just because a company has a mature dividend policy however, does not mean it is not growing. There are tens of dividend achievers and dividend champions which are growing their business, and distributing the growing pile of excess cash flow the generate each year to shareholders in the form of higher dividends. Companies in the mature phase of paying dividends tend to be established in the industries and tend to be number one or two in their respective fields.
Examples of other companies in the mature stage include McDonald’s (NYSE:MCD), which has increased distributions to shareholders for 36 consecutive years. While it has paid and increased distributions at a high pace over the past decade, it has still not paid a large portion of its earnings as dividends. Only in recent years, has McDonald’s been able to pay out a significant yet sustainable amount of earnings out to shareholders. The company is paying an annual dividend of $3.08 per share, and its earnings in 2013 are expected to be $5.78 per share. Check my analysis of McDonald’s.
Companies which experience declines in their businesses, while still paying the high dividend might end up reassessing where cash goes. As a result of this assessment these companies might have to identify the need to cut or eliminate distributions, in order to preserve cash. Many financial stocks in the 2007 – 2009 recession cut or eliminated dividends when their near-term outlook turned gloomy.
While many companies that cut or eliminate dividends do so in order to avoid facing liquidity problems that would make them go under, others do it simply to in order to conserve cash. Typically the chance of a dividend cutter going under is similar to 50-50. In other words some would end up going under, just like Lehman Brothers (PINK:LEHMQ) or Washington Mutual, while others like General Electric (NYSE:GE) or Pfizer (NYSE:PFE) will continue on. In general, companies in the decline phase could easily move back to initial or mature phase once their business turns around.
So why is it important to know these phases? It is important if you are planning on living off dividends in retirement to understand what phase your income holdings are in. In general, companies which tend to increase dividends higher than the rate of earnings growth can do so until their dividend payout ratios reach unreasonable levels. While these companies have above average dividend growth, their yields are typically low and dividend growth is not a true reflection of earnings growth, which is the true driver of shareholder wealth. After that, future dividend growth will be limited by the growth in earnings.
In general, I tend to purchase companies in the mature stage of dividend growth, since these are the real wealth creators from capital gains and dividend increases. Companies that can generate higher earnings over time, will have the ability to pay higher dividends and would likely be viewed as more valuable by shareholders.
Full Disclosure: Long MCD