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Shares in companies which have made a commitment to increase their dividend year after year are called dividend growth stocks. These are one of the best and most accessible investment types available for creating a passive income source for financial independence.

Many see the stock market as risky and stay away from it out of fear for losing their money. Caution and skepticism is a good trait as an investor, but staying away from stocks altogether is usually not the best way to accumulate personal wealth. Risks can be managed, both by diversification to spread the risks but most of all by being interested in what the companies you own actually do.

Being a stock owner means that you own part of the company. Indirectly, all the employees are working for you, stressing and agonizing about what they can do to meet the targets set by the company leadership who in turn answer to you and the rest of the owners. Being interested in the business, reading up on the market and being aligned with the rest of the owners is one of the fundamental criteria that needs to be fulfilled before investing in a company.

Dividend Aristocrats

A large number of companies have an outspoken goal of increasing their dividends every year, those who have succeeded in doing so for more than 25 years are called Dividend Aristocrats or sometimes Dividend Champions. These companies have demonstrated a financial stability, a steady growth and commitment towards shareholders during multiple cycles of market ups and downs. Many of these companies have streaks of increasing dividends that lasts 40 years or more, showing a resilience against financial turmoil, IT-busts, housing bubbles, global political squabbles and the ability to evolve their business with the times.

Investing in and creating a portfolio of these companies is a great way to build an ever growing passive income stream. The most important thing to remember is that it’s not really the value increase of the stocks that’s interesting when owning these. The goal with dividend growth investing is to accumulate cash flow from stocks as a passive income stream for financial independence. As long as the company continues to grow its earnings it will also be possible for them to increase the dividend – and this is where it’s important to pay attention as a stock owner.

Fortunately there are quite a few of these and many that have taken a mission on themselves to continue increasing the generated dividend year after year as a way of returning value to their shareholders, rather than only finding ways to maximize the stock price – which only rewards those who choose to sell their share of the company.

A number of the U.S. based dividend growth companies can be found in two stock indices: the S&P 500 Dividend Aristocrats index and the S&P High Yield Dividend Aristocrats. These indices track companies in the S&P 500 that have increased their dividend for more than 25 years and companies in the S&P 1500 with more than 20 years of dividend increases, giving a quick overview over companies that are interesting for a dividend growth stock portfolio. There are mutual funds available that mirrors these indices, giving a very easy way of investing in dividend growth stocks.

While a fund is an easy way to invest in stocks it might not be the optimal way for every individual. Buying company stock directly puts the investor in the driver’s seat and makes it possible to tune the investment portfolio according to different parameters. For example, you might want to stay out of certain stocks or markets and a broad index fund won’t let you do that.

Before investing in any stock a proper due diligence on the current situation and future prospects needs to be undertaken, understanding the market the company is operating in and whether they have a positive outlook. Listening in on or reading the transcripts from the quarterly earnings calls is a good way to hear how the company leadership look at the situation as well as how both positive and critical analysts look at the company and the existing opportunities as well as challenges ahead of them.

How to invest in dividend growth stocks

We must also ask ourselves if we can stand behind the company and the products or services it produces. Once we’ve accepted what they do, or are perhaps even enthusiastic about it, we need to find out if it’s a stable enterprise that can continue to grow its profits and an ever increasing dividend.

One way of doing this is to evaluate the company based on:

• Fundamentals of the company, like payout ratio and years of dividend increases
• Dividend returns, what you get for owning the stock
• Fair value, the price in relation to the value per share

Our main reason to own a company is to receive dividends – and for the company to be able to distribute profits it must be profitable, now and in the future. There are a number of financial metrics that can help us evaluate the current and expected future performance of the company. We call these metrics Fundamentals since they’re the very foundation of a healthy company.

For a company to keep increasing its dividends it needs to generate more earnings per share and the healthiest way to do this is by expanding the business and making higher earnings. Is the company growing or does it have a unique position to gain market share in a static or contracting market? Can it expand by moving into new markets? Are there threats to the overall market that can jeopardize the very existence of the company?

There are lots of examples of companies that have succeeded in changing with the times, like IBM, and companies which haven’t, like Kodak. We have to use our judgement in finding out if the company is of the type that creates its own market and can continue to do so decade after decade.

The longer dividend growth streak a company has, with suitable future outlook, the more sure you can be that you’ll receive your yearly income increase, without having to do anything at all also in the future. The Dividend Aristocrats all have more than 25 years of dividend increases, a very good benchmark showing the commitment from the majority owners and the Board over a long period of time.

There are also companies with shorter streaks that are interesting. For example, in 2016 Apple has one of the biggest cash piles of any entity on earth and a business with an unparalleled sustained operating cash flow making them interesting even after only couple of years of dividend payouts.

A healthy company distributes some of its profits to owners and the amount of money distributed in relation to earnings is called the payout ratio. A low payout ratio means there’s room to distribute dividends and even increase them even if it’s a bad year. Just like living well below one’s means, it’s means that the company has financial flexibility and can adapt, put extra resources into R&D or its sales organization, perform strategic acquisitions or some other action if needed.

The dividend and fair price

The dividend is the value we get from owning a stock and the reason for owning it in a passive income stock portfolio. There are two main components to look at, the dividend compared to price (yield) and the expected future dividend growth.

Since the yield will change with the price of the stock it’s possible to get vastly different yield on invested capital depending on whether the price was high or low when the stock was bought – with the actual dividend per stock remaining at the same level. As stocks come in and out of fashion, which can happen several times per year, opportunities will arise to buy solid companies at a good price and with a stronger dividend than usual. However, a yield for a stock that’s way out of proportion and much higher than its peers is usually a sign that the investment market is weary of the stock due to looming problems or uncertainty for future prospects.

With the yield being the driver for current value from owning the stock, the dividend growth is the driver for future returns. Most salaried workers would be very happy with a 10% raise year after year, and so should we be if we can find companies that can provide this.

It’s the combination of yield and dividend growth that provide powerful returns for the investor, so both of these indicators are important. Also important to remember is that as long as the original investment is still tied up in the stock it’s the yield on cost that’s important and not the current yield on price. If the price of the stock goes up or down has no impact for the owner.

No matter how great the company is, a stock won’t be a good buy if the price is too high. The yield will be relatively low compared to what it could be and upwards room for value increase is reduced as well. Many companies has share prices that fluctuate more than their average yearly dividend increases, so buying at the wrong time basically sets you back one year of dividend growth.

So how do we know when we have a good price? While one cornerstone of modern financial theory, the efficient-market hypothesis, states that the stock price always reflect all relevant information and thus reflects the fair value for a share, this is simply not true. The market is driven by a herd mentality as much as sober evaluation of the facts. This leads to opportunities when the market overreacts to news which has no impact on the underlying fundamentals.

One such example was the Brexit vote in Great Britain in 2016, when the news that the British people had voted to leave the European Union shook the world’s stock exchanges over the next week. However, once reality had settled in, that there’s no immediate danger and that the world as we know it won’t end right there and then, the markets rebounded to even higher levels.

Not all situations has to be that dramatic. Sometimes a stock simply loses favor with investors, maybe there’s a more exciting competitor or there’s a lack of news that filters through, that will lead to a reduced price simply from the fact that fewer people are interested in buying the stock. This is market economics at work, where the price is what the market is willing to pay. This has nothing to do with the underlying fair value of the stock though.

What the stock should cost, given the earnings and assuming information on the future growth, can quite easily be approximated. The easiest way is to look at the price to earnings ratio (P/E ratio). The historic mean P/E ratio, from the 1870’s to 2016, has been 15.6. What this means is that we’re paying on average 15.6 times the profit when buying a stock. What this doesn’t take into account is the growth rate of the company, for a company that grows its earnings per share faster than the average there’s a good case to be made that it should also command a premium valuation compared to its peers.

However, there are methods to use that give a better answer. Benjamin Graham and David Dodd presented a formula very usable for slow growing stocks in The Intelligent Investor and other formulas based on the earnings, growth and/or other indicators have been developed.

Stocks will usually follow these approximations of value and then deviate from it, going in and out from being priced at the fair value. Some stocks always command a premium compared to the formulas and some are deemed risky by the market and follow a more or less constant rebate to the fair value. It’s possible to observe the price and fair value history and see how it has performed over time.

Whenever the price is below this value the stock is effectively on sale and a potentially good buy. When it’s above the fair value it’s momentarily overvalued. Most stocks snaps in and out of alignment with the fair value curve so a powerful technique to get strong returns is to buy stocks on rebate and then sell them once they’ve re-aligned themselves with the fair value. The returns are usually not huge but can be quite fast which creates strong profits on a yearly basis. Of course, sometimes the stocks continue down and sometimes they’re stuck in an undervalued position for years at a time. Nothing to do then but to reap the benefits of the dividend, not too bad that either.

The Flip has found a new home! Check it out on http://www.theflip.nu or the blog on Medium.