Investors seeking income are typically drawn to the highest yielding shares. This makes sense to some extent, but the potential for dividend growth should not be overlooked when deciding which stocks to invest in.
As a general rule, companies with the highest trailing yield will not have the greatest potential for dividend growth in coming years. A stock with a moderate yield and high growth may quickly prove to be a superior investment for long-term investors.
This is the power of compounding. A stock which is increasing its dividend by 10% a year will double its dividend payments after around 7 years.
Some of the best income stocks never offer a high yield, as the dividend payments and the share price continue moving higher together.
Among the best examples is Ramsay Health Care Limited (ASX: RHC). It is one of the very few companies on the ASX which has increased its dividend every year since 2000. Research from BKI Investments showed that an investor in Ramsay in 1999 (when shares were $1) has since received $6.15 in total dividends including $1.01 in dividends per share in 2015 alone.
However, at no point has the dividend yield been much higher than around 3%, as the share price has grown steadily to the current price of around $72.
Analysts expect further dividend growth to $1.20 per share in 2016 and $1.36 per share in 2017, suggesting a current yield of around 1.6%.
REA Group Limited (ASX: REA) is not generally thought of as an income stock, but its dividend payments have grown substantially in recent years. An investor in 2012 received a dividend of 33 cents per share (cps), representing a yield of under 3% at the time. This has since doubled to 70 cps paid out in 2015. Analysts expect dividends of 87.9 cps in 2016, and $1.08 in 2017.
REA Group's competitive advantage comes from its network effect. If this can be sustained, it is likely to continue to reward investors with capital gains and growing dividends for many years to come.
Domino's Pizza Enterprises Ltd (ASX: DMP) has been one of the best growth stocks on the ASX in recent years in terms of share price appreciation, however, it has also been a great income stock.
An investor in Domino's in 2005 has now received nearly their entire investment back in the form of dividends. This is despite Domino's never trading on an unusually high yield – as the share price has raced ahead along with the dividend payments.
Domino's paid 26.44 cps in dividends in 2012. This grew to 51.8 cps in 2015. Consensus forecasts are for dividends of 66.5 cps and 87.6 cps for 2016 and 2017, implying a current yield of around 1%.
Fund manager Magellan Financial Group Ltd (ASX: MFG) is another company which has grown its dividends substantially in recent years. It paid out around 75 cps in 2015, nearly doubling the payment from the prior year.
Analysts' forecasts for 2016 suggest further dividend growth of around 23%, implying a yield of 3.7%.
Long-term growth in Magellan's profits and dividends will depend on the performance of its funds and how successful it is in continuing to grow its assets under management.
Challenger Ltd (ASX: CGF) has increased its dividend by around 14% a year over the last decade.
Analyst consensus suggests further growth in the next few years as Challenger's annuity business looks set to benefit from the tailwind of Australia's ageing population.
Shares are up over 40% in the last few months, which has reduced the current yield to around 3.4%.
