Why dividend growth stocks generate powerful capital gains in the long term

Dividends capital gains

People often think of dividend stocks as ‘boring’ stocks that are only suitable for retirees. However, executed properly, a dividend growth strategy is capable of generating significant capital growth over the long term. Here’s a look at how dividend growth stocks can deliver capital gains for their investors.

Dividend growth example

Consider a hypothetical company – Company A. Company A is a high-quality company that has an excellent record of generating consistent revenue and earnings growth. The company also has a fantastic record of increasing its dividend payout by around 8% year after year.

Company A currently trades at 1,000p and last year paid out dividends of 40p per share, meaning that its trailing yield is 4%. This year the company is expected to pay out 43.2p per share, a yield of 4.3%.

Now let’s say we fast-forward five years from now. And over the last five years, Company A increased its dividend payout by a healthy 8% every year, meaning that its dividend payout is now 63.5p per share.

If Company A’s share price was still at 1,000p, new investors would be able to come along and pick up a yield of 6.4%, considerably higher than the market average. Buying Company A with a yield of 6.4% would be a ‘no-brainer,’ given the company’s history of revenue and earnings growth.

Rising dividends lead to rising prices

In an ‘efficient’ market, that opportunity simply wouldn’t exist.

As Company A increased its dividend over time, the chances are that investors would have been willing to pay more for the higher dividend payout, putting upwards pressure on the share price.

So in reality, Company A might trade somewhere near the 1,600p mark, meaning that the dividend payout of 63.5p per share still equates to a yield of around 4%.

The result is that the investor who bought the shares five years ago at 1,000p has received a growing stream of dividends every year, plus a capital gain of 60%, simply by holding the stock patiently.

Now, the share price might not move upwards in a linear fashion. For example, Company A’s yield might fluctuate between 3.5% and 4.5% over the five-year period. However the key takeaway here is that a growing dividend puts upwards pressure on a company’s share price.

And that’s why a dividend growth strategy is so powerful, because investors can potentially enjoy the combination of capital growth and dividend growth, generating long-term wealth with minimal effort.

This article is provided for general information only and is not intended to be investment advice. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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