One of the mistakes investors commonly make when looking to add a dividend paying company to their portfolio is to simply look at the stocks with the highest current yield. This is calculated by taking the current dividend and dividing by the current market price. This should just be a starting point – but too often it is the start and finish of dividend analysis for many investors.
 

What matters at least as much – and sometimes more – is the dividend growth rate. That is, what will the dividend yield be five years or even ten years from today for an investor who wants to buy and put away an investment in a dividend paying equity.
 

From the data in the table, we can see that of the ten companies in the S&P 500 and S&P 100 indexes with the fastest rate of dividend increase over the last five years there is not a single utility or telephone company that ranks as a top dividend growth company. However, all too often investors start and stop with telecom and utility stocks when looking for dividend stocks. To take a look at what these dividend growth rates mean from a practical basis, we can look at the example of Comcast Corp. The company used to be penalized by the market in terms of its valuation because investors would often fear that the company would spend its cash flow on possibly risky acquisitions as it maintained a relatively small dividend. For a time this was true. As the company began to pay down its debt and cutback on acquisitions, the company has begun to ramp up its dividend. As it has grown its dividend by 21% annually, the dividend yield should be approaching 4% over the next four years at its current 5 year dividend growth rate.
 

One other metric that investors can use to gauge dividend paying equities is the payout ratio – or the percentage of profits paid out to shareholders in the form of dividends. Generally, a low payout ratio means that the company is able to enhance or increase its dividend growth rate. To see this, we can see that for some of the companies in the table the rate of dividend increase has appreciated significantly over the last five years when compared to the ten year rate of increase. In the case of Comcast, the payout ratio is only about 31% which provides good potential to increase the dividend over time.
 

One aspect of dividend investing that does not get a lot of attention is the fact that the greatest benefits of dividends comes from the compounding effect. For an investor to reap the rewards of compounding dividend growth rates requires patience and the ability to hold onto a company for years. From a portfolio perspective, a good dividend growth company with a good track record of growing earnings and dividends should comprise part of the “buy and hold” portion of the portfolio. Patience will be rewarded but it takes time.
 

In part, this is an example of how companies with strong profit growth rates who have current low dividend payout rates can be tomorrow’s high yielding stock through the compounding of dividends. For dividend paying investment opportunities, investors should look beyond just the current dividend yield.