Dividends form the core investment strategy for income-seeking investors.
While many companies do pay regular dividends, these payouts may fluctuate over the years depending on both the state of the economy and financial performance of the underlying business.
Some companies may fall by the wayside when their business is threatened by other competitors, and cut their dividends in response to falling profits and cash flows.
Red flags may also emerge for businesses that are experiencing prolonged stress and structural changes in the industry they operate in.
Truth be told, it can be tough to find companies that consistently maintain or grow their dividends.
Such dividend champions are rare, but when found, they can allow you to compound your wealth over the long-term.
If you want to grow your dividends, here are three things you should watch out for.
Businesses with growing addressable markets
Some industries can offer explosive growth for companies that have a first-mover advantage, or who are strong market leaders.
The potential customers that can be served within an industry are known as the “total addressable market” (TAM).
If a company has lots more room to grow, investors can reap the rewards from rising profits and dividends over the years.
Take the example of Domino’s Pizza (NYSE: DPZ).
The company is number one in the global quick-service restaurant (QSR) pizza market, with a 15% global market share.
Domino’s also has a track record of raising its dividends. Annual dividend per share more than doubled from US$1.24 to US$2.60 from 2015 to 2019.
Domino’s reported total revenue of US$3.6 billion for the fiscal year ended 29 December 2019.
The global QSR Pizza industry, however, is worth a whopping US$84 billion.
The company, therefore, only makes up a small slice of the total pie (or should we say pizza) and has significantly more room to increase its market share and profits.
With the increase in profits, dividend per share should also continue its upward climb.
Higher free cash flow
As companies grow and prosper, increased profits will also lead to the generation of higher operating cash flow.
The sign of a healthy company is one that consistently generates not just positive operating cash flow, but free cash flow as well.
Free cash flow is defined as the cash left over after capital expenditures are deducted from operating cash flow.
Capital expenditures consist of maintenance spending and upkeep that businesses need to spend on to ensure the smooth flow of operations.
Granted, businesses that grow in size will also end up spending higher amounts on capital expenditures as they acquire more plant and equipment or build more factories.
That’s why investors need to monitor if the growth in capital expenditures is also accompanied by higher operating cash flow generation.
Companies that rely heavily on external funding (e.g. issuance of shares or taking up of bank loans) are riskier in that they may not generate the requisite free cash flow required to reinvest their earnings back into growing the business.
Such companies may give the impression of growing their cash balance, but this is done through financing and not its core business.
Tying this back to dividends, the takeaway here is that companies with a steadily growing stream of free cash flow are also in a better position to pay out increased dividends.
When crunch time comes and a financial crisis hits, such companies are also better able to protect their dividend stream even though business volumes may plunge.
The offer of scrip dividends
A third and often neglected method of growing your dividends is through the acceptance of a scrip dividend scheme.
Some companies, such as Raffles Medical Group Ltd (SGX: BSL), offer shareholders the option of accepting either cash or a scrip dividend.
If you accept the scrip offer, you get to increase the number of shares you have in the company, without the need to cough up additional cash of your own.
Over time, even if the company’s dividend per share remains constant, the steady increase in the number of shares you own translates to a higher total dividend amount received.
And if the company’s dividend per share rises over time, it ends up being a double bonanza for the astute investor.
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Disclaimer: Royston Yang owns shares in Raffles Medical Group Ltd.
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