Retention Rate Is Important Factor For Dividend Growth Companies

Investing in a company that simply increases it dividend will not ensure an investor that the investment will yield higher returns. One factor to evaluate is the earnings retention rate. Retention rate is the amount of earnings left over after accounting for the dividends paid to shareholders. If a company pays all earnings to shareholders, then the earnings retention would be zero. If a company pays out 70% of its earnings to shareholders, then the company's retention rate would equal 30%.

David Wendell Associates recently published a newsletter noting dividend paying companies with higher retention rates than the S&P 500 Index tend to outperform the index over longer periods of time.

The table below shows the average retention and dividend growth rates over the past ten and five years for a number of companies we have recommended. As can be seen, since 1999 these companies, as a group, had an average retention rate of 17%, or more than four times the average of the S&P 500 for the same period. Their average dividend growth rates for the past five years were also far superior to the S&P 500 -- even taking into account the three companies in the group not paying dividends for the entire period.

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As can be seen, the retention rate of these companies, as a group, averaged well over four times that of the S&P 500 last year. Their earnings increased an average of 13% last year while the S&P 500’s decreased about 40% amid the carnage of the financial crisis.

These companies even outperformed the S&P 500 over the three years beginning in 2005 -- when the bubble in financial assets began. As a group, their earnings increased at a compound annual rate of 14%, versus the S&P 500 which declined at a compound annual rate of 16%. As a group, their dividends increased at a compound annual rate of 21%, versus the S&P 500 which saw an increase of 9%.

Finally, last year these companies increased their dividends an average of 18% while the S&P 500 saw a dividend increase of only 2%. For the current year-to-date, some of these companies have already announced dividend increases averaging 14%, while Standard & Poor’s is projecting S&P 500 dividends will likely decrease almost 23% this year.

One attractive aspect of investing in dividend growth companies is the investor can gain insight into a company's financial prospects by reviewing financial ratios that might deviate from historical norms because of the desire to maintain a certain dividend growth rate. In the David Wendell Associates article, the firm focuses on retention rate; however, other ratios may deviate from a company's historical norm such as leverage. If a company is borrowing in order to pay an ever increasing dividend, this could be a signal that the company's future earnings may not be as strong as anticipated.

In the end an investor can gain unique insight into a company's financial prospects by evaluating the impact the dividend growth rate has on other key financial ratios like leverage and retention rate.

Source:

Solid and Sustainable: Growth Company Dividends (PDF)
David Wendell Associates
First Quarter, 2009
http://209.62.111.98/~dwendell/images/1q09commonsense.pdf