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 could all set up complex equations to automate our investment decisions 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.

Next time, we’ll roll up our sleeves and dig into valuation basics.

You can bookmark all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.

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