More often than not, whenever you hear the term '10% dividend yield,' it's time to run for cover. In most cases, a super-high yield is a signal that the market has no faith whatsoever in the company's prospects and is therefore expecting its dividend to be cut in the near future.
However, what if there was an investing strategy that allowed you to enjoy yields as high as 10%, 15% or even 20%, without taking on any excessive risk or investing in high yielding stocks that could possibly see their dividends cut? The good news is that such a strategy exists.
Welcome to the world of dividend growth investing.
Consistent dividend increases
Dividend growth investing is the process of investing in companies that consistently raise their dividends. By investing in a company that does this, a 4% dividend yield, can over time, grow into a formidable double-digit yield, simply through the power of compounding.
The table below illustrates how dividend yields can grow over time.
5% growth pa
6% growth pa
5% growth pa
6% growth pa
Achieving a double-digit dividend yield isn't a complicated process, however two key ingredients are essential.
First, you'll need to identify and invest in high quality businesses that will grow their dividends for the foreseeable future. Ideally you're looking for dividend growth of at least 5% per year. Then, you'll need significant patience. A 4% yield won't grow into a 10% yield overnight. You're most likely looking at a 10-15-year holding period to see a 4% or 5% yield transform into double-digits. If you get panicked out of the market at the first sign of volatility, this strategy will be much harder to execute.
However with a little bit of research into quality dividend growth stocks and a buy-and-hold strategy, you'll have every chance of being able to enjoy sizeable returns in the future.
Dividend growth champions
Let's look at some examples of dividend growth investing in practice. Diageo and British American Tobacco are two companies that have grown their earnings and dividends strongly over time.
If an investor had bought Diageo shares 15 years ago at a price of 715p, the stock would have come with a dividend yield of 3.1% as 22.3p dividends per share were paid for FY2001. However if the investor still owned the shares today, they would now be receiving 59.2p per share in dividends, which is a sizeable 8.3% yield on the original purchase price. And with Diageo's dividend payout forecast to rise over the next few years, it wouldn't be long before the investor was enjoying a 10% yield.
Similarly, if the investor had purchased shares in British American Tobacco 15 years ago for 560p, the dividend yield at the time would have been 5.2%, as 29p in dividends per share were paid at the time. However, last year the tobacco giant rewarded shareholders with a dividend of 154p per share, which equates to an amazing yield of 27.5% on the original purchase price if the investor still held the shares.
These examples illustrate the amazing power of dividend growth. By simply holding onto high quality dividend growth companies for the long term, investors can be rewarded with incredible yields in the future, without taking on any extra risk.
Edward Sheldon has no position in any shares mentioned. The Motley Fool UK has recommended Diageo. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.