Companies with decent average dividend yields and reasonable payout ratios are thought of as reliable and safe investments that offer income as well as an opportunity for capital growth. The dividend growth model reflects how a company has performed in the past.

Since it is just an indicator of past performance, it will not guarantee how a company will do in the future. However, we can only use the information that we have to make an informed investment decision. So, in making an investment, the dividend growth model is a very useful tool for the construction of your portfolio of investments that seek to provide a growing income stream. However, it is not the be all and end all of due diligence that should be performed on a company.

To calculate how much a stock is worth based on the dividend growth model, you will need these three things:

1.)    Current dividend payout of the company

2.)    Growth rate of the dividend

3.)    Your required rate of return.

The current dividend payout and growth rate of a company can be researched online. I like to use Reuters as they display a lot of dividend information along with the other necessary financial information.

Your required rate of return is based on personal requirements for return on your investment capital.

How To Calculate Value Based On The Dividend Growth Model:

1. Add 1 to the dividend growth rate. For example, if the rate is 12%, add 1 to 0.12.
2. Multiply the sum with the current dividend payout. For example, if the payout is $1.50, multiply that by 1.12 to get 1.68.
3. Divide the product, 1.68, by your rate of return less the dividend growth. For example, if your rate if return is 20%, less dividend growth rate of 12% is 8%. Divide 1.68 by 8% or 0.08 and you get $21.

The above example values the stock at $21 based on a 12% dividend growth rate. Compare this value to the most recent closing price of the stock you’re considering. If the closing price is lower, then the model has indicated that this stock has met your criteria and is worthy of further consideration.   

The dividend growth model relies on variables that can change over time and, as such, can only calculate how the stock should be valued at the current dividend growth rate. As we have discovered from the most recent market downturn, dividends do not grow at a constant rate in perpetuity, so the value that we calculate using the dividend growth model can change!

Of course, as with any valuation model, there are risks associated with investing based on purely the dividend growth model. It does, however, provide a good data point for your investment analysis.

To know if the dividend growth rate growth can be sustained for many years, one can also evaluate the sales growth and profit margin trends. As market conditions change, it is useful to continue to run potential investments through the dividend growth model, accounting for changes in dividend growth rate and the dividend payout.

It is very important when investing to not only evaluate a company against others in its sector or industry, but also against itself.

In previous articles, we have discussed the dividend payout ratio, free cash flow, Z-Score and Return on Invested Capital (ROIC). All of these metrics are used as a way to evaluate stocks against their peer group, but also against themselves at different points in time.

When we have narrowed a company down against its peers, it is then time to evaluate the stock against itself at different points in time. Doing this can help us to determine if a stock is selling at a reasonable price.

How To Use Average Dividend Yield 

One of the greatest ways to evaluate a dividend stock against itself is to determine the average dividend yield that that stock has paid over the past number of years. If the stock has a higher than average yield, compared to its own historical average, then it may indicate that it is a better time to purchase shares (all other factors being equal).

There is an excellent tutorial on calculating average dividend yield at DividendsMatter.com. I will highlight some of the main points here, but I highly suggest that you read the full tutorial.

First of all, I like to gather 10 years worth of data for the stock. This is easy to do because the stocks that I analyze have very long histories of paying dividends. The information we need is the high and the low stock price, and the dividend paid out for each of the last 10 years.

This data can be gathered from many sources, including the company website.  However, I prefer to use Yahoo Finance because the dividend information can be filtered out from the stock price using this option.

This is all the historical information we need. Now, from this information, we can calculate the high yield and the low yield for each year. The high yield is calculated by taking the annual dividend and dividing by the low price. Similarly,the low yield is calculated by taking the annual dividend and dividing by the high price.

High Dividend Yield = Annual Dividend / Low Stock Price

Well Worth The Effort 

The mathematics of the process is very elementary, but it does take some time to gather the information.  This is certainly time well spent and I suggest that you practice on a couple of your favorite stocks. 

You will find that buying high quality, dividend growth stocks at prices above their average dividend yield will give you a margin of safety and confidence to hold the stock through thick and thin.

Obviously, this is one metric of many that will help guide you in your quest to buy quality dividend growth stocks. 

Please see: How To Choose Dividend Growth Stocks . for additional learning.

The substantial gains that are reaped by re-investing the growing dividends from our favorite stocks lies in the exponential power of compounding – which often takes years to build into a noticeable contribution to a portfolio.

Because the re-investment process can seem unproductive and the dividend growth insignificant at first, it is easy for others to dismiss dividend growth investing as “too conservative” or even unprofitable. As much as we preach that slow and steady wins the race, even the most seasoned dividend growth investor can begin to question the effectiveness of the strategy from time to time.

A Real Life Example

Many times it takes a real life example of dividend growth investing to help to keep one motivated to continue the long , often boring, journey of building a portfolio of dividend growing common stocks.

The recent bid by InBev to take over Anheuser Busch (BUD) provided this motivating real-life example that what the essence of dividend growth investing is all about.

This is what the “end-game” of our dividend growth strategy should look like – it’s beautiful!
In 1980, Sean Gorham bought his first piece of a public company: a $500 investment in Anheuser-Busch, even though he had no connection to the brewer or its St. Louis roots. He’s reinvested the dividends, or the cash payout shareholders receive, over the years.

“I’ve always admired how well the company is run. They exude a very clean image and a very American image,” said Gorham, 48, an insurance agent who lives in York, Maine, about an hour northeast of Anheuser-Busch’s Merrimack, N.H., brewery. “It’s been one of the best investments I’ve had. … The dividend I get every year is more than what I originally paid for” the stock.

Anheuser-Busch stock began being traded in 1933 in the over-the-counter market, where brokers buy and sell among themselves rather than through a stock exchange. The company first was listed on the New York Stock Exchange on April 18, 1980, making it more widely accessible to individual investors.

In the past 28 years, Anheuser-Busch’s stock has split four times. So one share bought in 1980 is now 24 shares – how’s that for creating shareholder value.

It Takes Time And Commitment

Obviously this example is one that has taken nearly 30 years to develop, but the fruits of the labor are tremendous.

Given this example, an investor who today is 30 or even 40 years old could begin to build a portfolio of dividend growing common stocks and expect to receive an excellent income in retirement that grows each year – likely at a rate higher than inflation!

When one commits to the strategy of dividend growth investing, it requires an extreme amount of patience and discipline in the first few years. It may take as many as ten years of dividend growth before the re-invested dividends make significant contribution to the growth of the portfolio.

Reaching The Tipping Point

Many financial planners will dub a person’s working years as the “accumulation phase” of one’s life. This means that during these years (roughly from age 20-65) the purpose of investing is to accumulate assets that will allow the investor to hopefully maintain their current lifestyle in retirement.

During the first decade or two, accumulating assets is the most difficult as investors tend to have other “important” expenses such as purchasing a home, raising a family, retiring student loans and consumer debt etc.

While a full blown discussion on the time value of money is not necessary in this article, one must recognize that buying assets such as dividend growth stocks during the early years of the accumulation phase will allow for the advantages of compound growth to kick in and the tipping point will be reached faster.

The tipping point is the point where the return from investments begins to grow at a greater rate than  expenses. You will notice that one does not say that investment income meets expenses because, it is known that expenses increase with inflation and (mortgage excluded) may actually have increased in retirement depending on medical needs etc.

Motivation To Follow A Proven Path

During the accumulation phase, success stories like the one above can prevent investors from straying from the proven path of investing in solid dividend growth stocks to fund a prosperous retirement.

Where do you get the motivation to stay committed to your investment strategy?

Resources: St. Louis Today

As a spin-off of the successful Duke Energy, Spectra Energy Corp (NYSE:SE) has had a rather successful first 16 months in business and has recently declared an 8.7 percent increase in its quarterly cash dividend
on its common stock, from $0.23 to $0.25 per share. The dividend is payable September 15, 2008, to shareholders of record at the close of business August 15, 2008.

Spectra has what appears to be a very assertive, yet stable, long term growth plan that is focused on organic growth and project development. This includes a very lucrative joint venture with Conaco Phillips and already transports some 12% of the natural gas consumed in the United States.

With these facts in mind, let’s take a look at what the Chief Financial Officer (Soon to be CEO at the end of 2008) of Spectra Energy, Greg Ebel has to say to investors looking to purchase stock in the company:

I think the key reasons are, first and foremost, a home grown stable of expansion projects that give visibility on earnings growth to the better-than-the-pack earnings growth and opportunities they see. Also, solid dividend growth opportunity, sound financial management and overall a relatively safe harbor in what is a somewhat dodgy financial market situation and economic situation we see out there today.

A Closer Look At Spectra Energy

Spectra Energy is one of North America’s premier natural gas infrastructure companies serving three key links in the natural gas value chain: gathering and processing, transmission and storage, and distribution. With very solid transportation contracts into the foreseeable future, there is little concern for profitability and optimism for increasing shareholder value. However, any lagging demand for natural gas would certainly be a concern for the company moving forward.

Spectra Energy owns and operates critically important pipelines and related infrastructure connecting natural gas supply sources to premium markets. Based in Houston, Texas, the company operates in the United States and Canada approximately 18,000 miles of transmission pipeline, 265 billion cubic feet of storage, natural gas gathering and processing, natural gas liquids operations and local distribution assets.

Spectra Energy Corp also has a 50 percent ownership in DCP Midstream, the largest natural gas gatherer and processor in the United States.

Why Pipeline Stocks?

It has been said before, but pipeline stocks are like railroads for natural gas. Simply put, the demand for natural gas is up and correlates somewhat with oil prices, but the upside with pipelines is that they do not have the competition from other forms of transportation. In order to move and significant volume of natural gas a pipeline must be used.

Pipelines are traditionally managed very conservatively, as is Spectra Energy, and make their money through cost-of-service contracts and other required services. This means that cash flow is relatively stable and predictable when compared to the market as a whole. This can be referenced by viewing the Beta coefficients of pipeline stocks which show significantly less volatility than the broader markets.

I have stated before, and I will state again that pipelines are great recession proof stocks.

On top of preserving and likely growing capital, investors can collect a healthy (and growing) dividend yield.

Spectra’s current yield is 3.28%.

Spectra also boasts Return on Equity and Return on Investment numbers that are markedly abov ethe industry average at 17.1% and 5.76 % respectively.

For those of you looking to preserve capital during these rough market times and collect a solid dividend, I highly recommend pipeline stocks. Along, with Spectra Energy I suggest looking at Trans Canada Pipeline (TRP).

Full Disclosure: The Author does not own shares of Spectra Energy, but does own some Trans Canada Pipeline.

Here is a quote that sums up how us dividend investors might feel at the moment:

…Because when everyone else is doing the logical thing and shoveling money into growth stocks that are shooting to the moon, only a big fat idiot would stubbornly sit on a portfolio of boring dividend stocks that are, for the most part, doing jack squat.

It’s interesting that he mentions high flying stocks like Potash Corp. and Research in Motion as being the ones that he missed out on, while he talks about owning our favorite dividend growers – banks, insurers, pipelines and drug makers.

How Far Can You See?

When investing in dividend growth stocks , it isn’t about making a killing this week or this month.

• It is about investing for the long haul and watching your dividend income rise consistently year over year while your “investor” counterparts are searching for the next hot tip.
• It’s about holding onto that dividend paying stock and not worrying about the stock price, as long as that dividend keeps growing.
• It’s about protecting your hard-earned money from inflation and making your money work for you.
• It’s about knowing the company can’t fake a cash dividend.
• It’s about money in your pocket.

Over the long term we know (and Heinzl reiterates) that dividend growing common stock prices also out perform those stocks that pay stable or no dividends.

So What Now?

There is a famous saying from Warren Buffett that goes something like this:

“Be fearful when others are greedy, and greedy when others are fearful”

Of course this is easier said than done, otherwise we’d all be running a multi-billion dollar company like Berkshire Hathaway.

While it may take some serious resolve to start loading up on some of our favorite dividend payers, most notably banks stocks, sticking to a long term plan will make you rich in the long run.

So, to echo the words of Mr. Heinzl I’ll end with this quote:

Am I going to sell my dividend stocks to buy these high fliers now? Hell, no. If anything, I’ll be adding to my existing positions, and reinvesting the extra dividends in even more shares to take advantage of the magic of compounding.

So, don’t worry about the water cooler talk and stick to your plan. Soon enough you’ll be saying goodbye to the water cooler forever when the compounding effects of your rising dividend income begins to exceed your salary!

Here’s to your wealth!