Dividend investing is an excellent option for novice and experienced investors alike. However, this form of investing can sometimes get tricky when it comes to business growth vs. earnings growth. Just because a company has a larger payout rate doesn't necessarily mean it's a good investment.
It's important to understand that business growth isn't always reflected in dividend growth, as higher dividend payout rates aren't always relative to the success of the company. If you don't understand this, you could be fooled into investing in a business that isn't really growing, but is instead fluffing its dividend rate. In the long-term, this practice is highly unsustainable and can ultimately lead to a failed investment on your end.
Real World Example
To put this concept in perspective, take two businesses, for example. Businesses A and B pay $2 per dividend share and $8 per earnings share. Based on this data, both businesses have a payout rate of 25%. Over the next 3 years, Business A experiences growth and is able to double their earnings per share to $16. They decide to keep their payout rate at 25% and increase their per share dividend rate to $4 as a result.
Unfortunately, Business B doesn't experience the same growth. To compensate and make their company more appealing to investors, they increase their payout rate to 100%, or $8 per dividend share. To an unsuspecting investor, Business B's 100% payout rate is far more appealing than Business's A mere 25%. However, the reality is that Business A is the one that is actually growing, and if Business B continues to fail to see any growth in their earnings, they won't be able to sustain the 100% payout rate for long.
Long-Term Sustainability Requires Tangible Growth
The most important takeaway is the fact that substantial, long-term dividend growth can only be achieved by an earnings growth on the part of the company's profits. A company can only grow as quickly as their earnings are growing. Don't be enticed by a larger payout rate that isn't backed by marked growth within the company. If you do, the long-term yield of your investment will likely be less than desirable.
Solid dividend investing requires vetting on the part of the investor in order to determine if the payout rates of a company match its earnings. If you're new to investing, working with an experienced advisor who can give you dividend investing advice is helpful when it comes to performing this due diligence.