Dividend growth investing allows you to construct a diversified portfolio of companies that pay and raise their dividends consistently. Most investors focus on dividend yield, but this is not the strategy that will provide you with a steady stream of monthly income. Living off dividends is a straightforward strategy that requires focusing on stocks that pay and increase their dividends over time.
A key benefit of dividend growth investing is that you can take advantage of a bear market while compounding your returns. Put simply you reinvest your dividends when the market is low to purchase more shares with less money.
When prices recover, you realize a higher return on the accumulated shares you have purchased during the bear market.
Another benefit is the growing dividends. A growing dividend suggests growing earnings. More than that, it suggests dividend growth compounding because you can calculate your portfolio growth on a higher number of shares and a higher dividend.
Moreover, you can hedge the inflation risk by raising your dividend income and maintain the purchasing power of your portfolio.
The 25x Rule in Dividend Investing
Based on your annual income, you can estimate how much money you want to earn from dividends. That said, you can start living off dividends using the 25x rule, which suggests that you should invest 25x your annual income to realize a portfolio return of 4% or higher.
For example, if you want to withdraw $80,000 per year from your retirement portfolio, you need to have $2,000,000 invested ($80,000 x 25). If you want to withdraw $65,000 per year, you need $1,625,000 invested, and so on. This rule-of-thumb gives you an idea of how much money you can withdraw from your portfolio by realizing an annualized 4% portfolio return.
Why 4%? Because your portfolio will, most likely, include long-term stocks that generate 7% or higher, and you should take a 3% inflation into account So, the actual return of your portfolio is 4%. The 4% retirement rule gives you an idea of how much money you can withdraw from your retirement account.
Here’s how your retirement account will look like after 10 years:
Your initial retirement amount of $550,000 remains intact, and you withdraw the 4% at the age of 55. Then, at 56, you withdraw $22,000 adjusted for an inflation rate of 3%, which is $22,000 x (1+3%) = $22,660. At 57, you withdraw $22,660 adjusted for an inflation rate of 3%, which is $22,660 x (1+3%) = $23,340 and so on.
Note that every year you withdraw more than 4% of your retirement account, which is the best case scenario if the markets go up.
Implement a Dividend Reinvestment Plan (DRIP)
A dividend reinvestment plan (DRIP) allows you to reinvest your cash dividends in the company and buy additional stocks on the dividend payment date.
The key benefit of a DRIP is that you increase the value of your investment with compound interest. Compounding means that you generate additional growth by calculating the reinvested dividends on the new total shares instead of the shares you originally owned. In that way, you accumulate faster a higher number of shares and a higher amount to reinvest in the DRIP.
For example, you own 500 shares of a manufacturing company that currently trade at $64.28. The company declares an annualized dividend of $2.22 per share, and you receive $0.555 per share, totaling to $277.50 per quarter for all your shares.
By enrolling in a dividend reinvestment plan, you are giving up $277.50 to purchase additional shares. So, on the dividend payment date, you automatically purchase $277.50 / $64.28 = 4.32 shares. Now, you own 504.32 shares, and the next quarter, you will reinvest $279.90 in the company’s DRIP.
Here’s what your investment portfolio will look like after 4 quarters:
So, you start out with 500 shares and at the end of the year you have 517.49 shares. If the stock price drops within a year, you will acquire more shares, which means more money to reinvest in the DRIP.
In fact, through reinvestment you gain additional equity in the company and in a market downturn you won’t sell your shares because you will gain from reinvestment. Also, some companies raise their annual dividend, so again, you will be able to purchase more shares.
In Q4, the company raises its dividend 10%, and the annualized dividend becomes $2.44. In the meantime, the stock price has dropped to $51.28. Now, you own 520.61 shares.
The additional shares are commission-free.
DRIPs are allowed for an accumulated amount of $10 or more.
Using DDM for Choosing Dividend-Paying Stocks
DDM analyzes companies that pay a dividend on a regular basis and it calculates the present value of the company by discounting its dividend. The goal of the model is to calculate the real value of the stock and determine whether it is overvalued, undervalued or fairly valued.
To better understand how the DDM works, consider this:
Financial analysts estimate an annual growth 6% for the manufacturing company whose shares you own. The company pays an annualized dividend of $2.22, and the discount rate is 8%. So, to discount the dividend of the company at 8%, you calculate its present value:
Based on its dividend, the true value of the stock is $111.00. Since the stock trades at $64.28, it is undervalued, i.e. it trades lower than its true value. Undervalued stocks signal a buying opportunity because they have room for growth until they rise to their true value.
Of course, not all stocks pay dividends, and not all dividend-paying stocks are the same. There are all sorts of valuation metrics, such as P/E, P/BV, P/CF, market cap and so on that can give you an idea of the company size.
Dividends can tell you more about the value of the company. As a value investor, you know that you have to wait and capitalize on long-term returns. Even stocks that pay small dividends may have a remarkable growth potential.
This kind of investing can eventually turn into living off dividends, provided that you know why you are selecting one stock over another.