You know a lot about business now.
I’m being serious.
Forget trying to get that MBA.
You don’t need it.
What you’ve learned so far are the essential parts of building your business — “You Inc.”.
From boosting your revenue to pushing costs low, you could dominate the conversation with any professor of business or finance.
No joke.
I wouldn’t be surprised if 8 out of 10 of their students couldn’t even lay down these overarching principles.
I wouldn’t be surprised if 9 out of 10 of their students are deeply in debt or even on the brink of bankruptcy.
But this guide is more specifically about how dividend growth investing can help you with your business and that last stretch of turning a profit and most importantly a consistent income stream.
And to start a dividend growth portfolio, you need to know which dividend growth stock to buy.
While there are a ton of ways to select the perfect dividend growth stock, most people kind of fall, trip, and stumble upon ways to find one.
You, on the other hand, are different.
You don’t just want to make decent money.
You want to make good, steady, growing money.
And that requires a plan for stock selection.
When it comes to dividend growth stocks, there are four main metrics that investors base their choices on:
- Dividend yield
- Dividend growth streak
- Payout ratio
- Price-to-earning ratio
The dividend yield of a stock always seems appealing to people because they are easy to understand.
The dividend yield is a percentage of the share price which the company is paying out as a dividend.
Its calculation is as follows:
Dividend yield = total dividend amount to be paid in the next 12 months ÷ latest share price.
Intuitively, a stock with a dividend yield of 8% will pay out proportionally more dividends compared to a stock that yields 1%.
There can be good money with high-yielding stocks if the companies can safely afford that dividend indefinitely into the future.
But that’s actually the main problem with high-yielding stocks.
A company needs a LOT of money to sustain that high dividend yield and to have a LOT of money that company needs to pull in a LOT of sales and to have a LOT of sales that company needs to spend a LOT on the cost of producing the products to meet the sales which eats into the pool of money used to pay those dividends.
See the cycle?
Many investors fall into the trap of picking a bunch of high-yielding stocks once they’ve opened their brokerage account because having more dividends now is better than no dividends, right?
Wrong.
Because a high dividend yield is a red alert.
You have to investigate why the dividend yield is so high.
Is it because the company made a huge one-off special dividend last quarter that it’ll not be able to afford in the next?
Is it because the stock’s price dropped drastically due to worsening business fundamentals (recall the calculation for dividend yield; a price drop will make the dividend yield higher)?
Is it because the company is burrowing debt to pay such a huge dividend just to please investors while it’s paying through its nose?
If you put together a $10,000 portfolio of stocks yielding 8%, then you might make $200 every 3 months.
That’s pretty decent money for starters — at first glance.
And then the company couldn’t afford that dividend next quarter, or its stock price tumbles because of poor business fundamentals (you’ve earned the dividend but lost even more on capital depreciation), or worst, it goes bankrupt because of a fraud investigation and you end up with nothing.
When you’re busting your ass after working through what we’ve talked about so far in this guide and you see that you’re making two hundred bucks every quarter and then losing everything that can be very discouraging.
However, if you aren’t making a lot of dividends at the start but you know that you’re building up to something bigger, that can be encouraging.
Unfortunately, even if you aim for less-than-high-yield stocks, the problem is that you still don’t know if it’ll pay you next quarter, and if it will, how long the dividend will last.
That leaves you with the dividend growth streak, payout ratio, and P/E ratio as potential measures for choosing the right dividend growth stock.
For the sake of simplicity, consider all of these just as limited individually in answering the above questions because none of them can provide a complete picture of a stock’s quality.
So that means we are in the realm of stock screeners.
Don’t get scared.
Stock screeners aren’t bad and in fact, when you screen stocks the way that I’m showing you, you’ll find that you’re actually crystal clear on what you’re screening for as opposed to those online programs or apps that run through a black box.
It’s pretty great.
But to understand stock screening, we need to understand how a company pays a dividend.
Why Do Companies Pay Dividends?
Most of the time a company pays a dividend because they have too much cash on hand.
More specifically, a company pays a dividend when they believe that the excess cash will provide shareholders with better returns if distributed as a dividend instead of using it in other avenues (e.g reinvesting back in the business, acquiring another company, etc.).
Otherwise, what’s the point of paying a dividend?
Take Apple Inc. for example.
The company hauled in a whopping $104 billion from its day-to-day operations (AKA operating cash flow) in 2020 and only needed a meager $11 billion to keep the business growing (AKA capital expenditures: paying designers to keep designing, maintaining factories to keep manufacturing, and reinvesting in hiring more designers and more factories for future revenue growth through more designing and manufacturing).
So what does Apple do with all the excess cash in between?
This excess cash is known as the free cash flow.
It is calculated by subtracting capital expenditures from operating cash flow.
And there are a number of ways Apple can spend this money:
- Reinvest into the business
- Pay down debt
- Buy back shares
- Distribute a dividend
Apple could reinvest more in its business.
But since Apple is already so efficient at what it does and it is already such a huge company, it’s hard to move the needle with additional reinvestments that’ll generate significant returns.
Apple could pay down its debt.
But since Apple does not have that much debt relative to its size and is borrowing at a very low-interest rate given its good credit standing, paying down debt faster wouldn’t save shareholders a ton of money.
That leaves us with share buybacks and dividend distribution, which are exactly what Apple has been doing over the past 10 years.
These are ways to provide shareholders with the highest returns when reinvestments and debt repayment are less of an impact on large, established companies like Apple that are practically printing dollar bills in the form of free cash flow.
Both allow investors to share the fruits of Apple’s success.
While we’ve gained an intuitive understanding of how dividends allow us, investors, to become a partner with Apple splitting the business’s profits, share buybacks may require some more explanation.
When Apple buys back its own shares, it decreases the total share count.
This increases the proportion of the business that each Apple shareholder is entitled to.
Say you own 1 of 10 shares of Apple so you own one-tenth of the company.
If Apple buys back 1 share over the next year, there’ll be 9 shares left and you still own 1 share of Apple.
By now, you’ll own a larger piece of the business (one-ninth) without you having to lift a finger.
So back to our initial question of why a company would pay dividends.
More specifically consistently growing dividends.
It’s because most likely the business is doing so well already that the company has no better way to share profits with its owners than to pay them back in cash.
The business is just THAT great.
It’s important to understand this concept because if you don’t then you’ll get lucky strikes, but you won’t get the reproducible results that you want in stock picking.
If you can figure out what quality allows a company to afford a growing dividend, then you can single them out from the crowd and that will give you a great chance of making money.
But you’ll notice something in the previous paragraph.
This all depends on understanding what you are supposed to look for.
And this is exactly why the Dividend Lab Manual approach can be so effective.
Because you’re focusing your efforts on a small group of dividend-paying stocks then you know how these companies operate their business models of revenue and expenses.
Because you know their business models you also know what are the critical aspects that will predict how sustainable their dividend might be.
Because you have a clear set of criteria for picking out the winners, you are less likely to be swayed by emotions or biases in singling out the perfect dividend growth stock to generate the growing income stream you’re looking for.
Makes sense, right?
And once you’re done with amassing a portfolio of winning dividend stocks, you can repeat this process with minimal effort to weed out the underperformers and discover new winners in a low-maintenance portfolio.
Over time, you’ve identified several dependable dividend growth stocks that are all doing their job in providing cash flow for your lifestyle.
If it takes years if not decades to make your first $1 (realized gains and not paper gains) with trading for price appreciation (if your stock shot up in a straight line), it only takes 3 months at the longest to receive your next dividend paycheck with dividend growth investing.
Remember I said at the beginning that I wanted to make money in cash as quickly as possible with an investment portfolio?
I can do this by purchasing a dividend growth company with consistently growing revenue that’s paired with consistently low costs of operations, resulting in consistently growing profits from which they are able and willing to pay consistently growing dividends.
This isn’t a hard concept to grasp but it’s a hard concept to stick with.
Why?
It’s very easy to get lost in the trap of chasing big price gains.
It’s what most people sell you on when it comes to investing.
But what happens when everyone is doing that?
How else do you achieve the results that you want (make more money) other than by doing stuff better than them?
Can you predict the stock price more accurately?
Maybe.
Maybe not.
A lot of that is out of your control.
Can you choose to invest in a good business?
Most definitely.
That is 100% within your control.
You don’t try to win in this investing game by hopping on a bandwagon that seems to be heading to the moon and believing that you can jump out to safety right before it falls down the cliff AND right before everyone else.
You win by getting off the bandwagon right now and choose to take the train that’ll go nowhere near the moon but know with certainty it’ll bring you to the snow-capped mountain top.
As we have seen, the reality is that most wonderful, dividend-paying businesses are large, established companies that dominate their industry and are only able to grow at a reasonable single-digit growth rate instead of the unrealistic targets of 100X.
It’s why you should get your expectations right.
It’s why you find companies with solid histories of paying steady dividends and see if they are able and willing to safely continue those dividends into the future.
Once you have such a company you turn your focus to whether today’s price is a fair one to pay for the value you’ll get.
It’s why you focus your energy on dividend growth stocks because the reality is, a durable dividend has been and will always be a sign of quality for businesses.
Your goal with investing is to establish a profit-sharing partnership with other quality businesses.
The investors that do that tend to last longer and build portfolios that continue to make them money month after month without the need to expend more life energy on this endeavor that was supposed to free us from the same chains.
If you don’t see the value in this approach to investing then you will not want to continue here.
You can go back to trying to find the penny stock that has no revenue, a monster debt, and an even sinister hype on the promise of a TikTik Finfluencer.
I wish you the best of fortunes and I do not say that sarcastically.
However, if you understand the value of principled business fundamentals in a hyped-up market, then let’s continue moving forward by looking at the main aspect of dividend investing, which is a valuation system to identify value stocks.
What to look for and how to look for it.
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