Why dividend growth could be a multibagger signal

An investor who invested in Games Workshop (LON:GAW) 10 years ago might have paid around 500p per share for their shares.

If they’d held on to those shares, they would have received 420p per share in dividends alone during the company’s 2024 financial year.

Assuming broker forecasts are correct, our lucky long-term investor will receive 471p per share for the 2024/25 financial year. That’s a dividend yield on purchase cost of 94%.

I’d imagine this yield figure could easily reach 100% over the coming years. That would see our model investor receiving the entire cost of their original investment back in cash each year.

That’s not all. Since January 2015, Games Workshop has paid a total of 2,281p per share in dividends. That means these shares have been a dividend multibagger over the last decade, generating a 350% return from income alone.

Alongside this of course, Games Workshop shares have multibagged themselves. More accurately, the stock has been a 28-bagger, delivering a 2,750% profit over 10 years.

How significant is dividend income?

When set against the scale of Games Workshop’s share price gains, the income generated by the stock may first seem like a sideshow.

Indeed, I suspect that many growth-focused investors sometimes see dividends as an incidental. Nice to have, but not really relevant to the investment case.

I can understand the reasons for this. But what if dividend growth was actually an indicator of underlying growth potential, rather than just a symptom?

Alex and I have been doing some research that seems to suggest exactly that. We’ve found that companies that are able to deliver strong, sustainable dividend growth may also be those with above-average growth potential – possible multibaggers.

Here’s a summary of the approach we took:

• Alex gathered data on dividend-paying UK shares that have been listed for the last 10 years and ranked them by compound average dividend growth over that time.

• We then took the top 30 and bottom 30 stocks in terms of dividend growth and compared them using various fundamentals, both out the outset (2014) and on a 10-year average view (2014-24).

• Finally, we compared the total return (share price change plus dividends) from our top 30 dividend growth winners with that of our bottom 30 losers.

Spoiler alert! Over the 10 years from 2014 to 2024, there was a remarkable difference in total return between our winners and losers:

Read on for a summary of the fundamental factors we found that were common to the winning shares.

Dividend cover: look for high quality retained earnings

To deliver sustainable, self-funded growth, a company needs to be able to reinvest a sizeable chunk of its annual profits. This is difficult if it’s distributing too much as dividends.

It’s also important that the earnings are high quality – in other words, that they’re converted to free cash flow. Non-cash earnings cannot be used to pay suppliers’ bills or employee salaries.

Our findings support the common-sense view that the best dividend growth stocks have relatively high levels of dividend cover and earnings that are converted consistently into free cash flow:

Interestingly, the 10-year average free cash flow dividend cover for the losers was higher than earnings cover. This might seem attractive at first glance, but it’s a characteristic I typically associate with ex-growth stocks or companies going through cyclical downturns.

For example, one reason why free cash flow may exceed earnings is that past capital expenditure is not being matched by new growth investment. This can lead to a situation where profits are depressed by high depreciation charges (non cash), but free cash flow is boosted by the absence of growth capex.

In a genuine growth business, capital expenditure is more likely to match or exceed depreciation and amortisation charges. This is necessary for the company to increase its capital employed and thus its earning capacity.

Yield: 2 key numbers to look for

The relatively high level of dividend cover shown in the chart above is likely to imply a dividend yield around the market average, or perhaps slightly below. That’s true, as we’ll see below.

However, we found that there may also be a second type of yield that’s useful as an indicator of potential long-term performance.

Earnings yield (calculated as EBIT/EV) is a valuation measure I use heavily in my own investing, often instead of the P/E ratio. I like it because it reflects both debt and equity capital and is, in my view, far more inclusive and better suited for multi-stock comparisons than the P/E ratio.

There’s a good explanation of earnings yield here – it’s a metric favoured by noted US investor Joel Greenblatt, who used it in his Magic Formula.

When comparing our dividend growth winners and losers, we looked at both dividend yield and earnings yield.

Here are the results for 2014:

As a rule of thumb, I tend to think that an earnings yield of 6%-8% is likely to be decent value for a growth business.

At the start of the study period, we see that our winning stocks have low dividend yields paired with fairly attractive earnings yields.

In contrast, our losers have higher dividend yields, but are also more expensive, as highlighted by the lower earnings yield. This is likely to imply some combination of higher leverage, a higher payout ratio, or a higher valuation relative to earnings.

The average dividend yields for the winners and losers remain almost unchanged over the 10-year period, but something interesting happens to the earnings yield of the losers:

Our winning stocks remain attractively valued, with an earnings yield of nearly 9%. But on a 10-year average view, our losers are even cheaper, with an earnings yield of c.12%.

Individual circumstances will vary, but one interpretation of this might be these stocks have become cheap for a reason. As above, possible explanations might be that their growth strategies have misfired or they operate in a sector where cyclical slowdowns periodically outweigh any underlying growth.

While this doesn’t necessarily make them bad businesses, it may mean that they don’t have the compounding potential of the best dividend growth stocks.

Low debt, strong cash generation

It probably sounds obvious, but our data suggests it pays to focus on companies with low leverage and strong cash generation relative to their debt levels.

The two leverage ratios we chose for this comparison were assets to equity and free cash flow to debt. These are both available in the screener.

Here’s how our winners and losers compared in 2014:

And here’s how these ratios averaged across the 10-year period:

I think the patterns are fairly clear. While highly-leveraged companies can theoretically sometimes deliver impressive returns on equity, the risks of a mishap are much higher too. Sustaining such a strategy for 10 years is likely to be difficult.

In a similar vein, companies where a big chunk of cash flow is required to service debt are likely to struggle to invest optimally in growth without rising leverage. This can become a vicious circle, often ending poorly for equity holders.

I would suggest Victoria (LON:VCP) as a recent case study of what can go wrong with a debt-fuelled growth strategy.

Above-average profitability

There are lots of reasons why more profitable companies can be more profitable investments. But perhaps the simplest is that if companies do not generate returns in excess of their cost of capital, they struggle to generate the surplus capital they need to self-fund growth.

As a result, they are forced to rely more heavily on debt, stop growing, or reduce dividend payments.

Alex’s data-wrangling shows that more profitable companies are likely to deliver stronger dividend growth, albeit with on initial apparent exception for return on capital employed (ROCE):

Once again, however, I think this initial high ROCE is actually a possible warning.

When we pair higher ROCE with the higher dividend and earnings yields we saw earlier, I think what we’re really seeing is that some of these dividend growth losers are not really growth businesses at all. They’re either cyclical or on the verge of becoming ex-growth.

The 10-year average ROCE comparison supports this view, in my opinion. Our winners have seen average ROCE increase to a high-quality 20%+. But for the losers, ROCE has dropped to single digits.

For some reason, the earning power of the losers’ assets has fallen sharply over time. This most likely explains why their dividends and share prices have also underperformed the winners.

While the losers’ return on equity (ROE) appears relatively resilient over the 10-year period, ROE can be inflated by increased debt. ROCE and ROA cannot.

Remember earlier that our losers also had notably higher leverage than the winners.

StockRanks: Quality and Momentum trump Value

Stockopedia provides the data and screening tools needed to hunt for good dividend growth stocks. But can we simply use the StockRanks instead to identify potential winners?

A comparison of the StockRanks and QVM ranks for the winners and losers suggests some clear patterns. Here’s how the two groups compared at the start:

The winners and losers were equally matched on StockRank and QualityRank at the start of the study period. But winning stocks had stronger momentum and weaker value scores. In other words, they fitted the high QM profile of potential High Flyers.

In contrast, our losers more closely matched the QV bias of the Contrarian style. This is also a winning profile, but not necessarily one suitable for a compounding growth strategy.

Averaging the ranks over 10 years emphasises these conclusions. The losers ended up ranking lower on every metric except value. They have become more average (and cheaper) over time, while our winners have become more highly ranked (and more expensive).

Conclusions: next steps

If this all sounds a little familiar to you then I would not be completely surprised. In my opinion, the findings I’ve outlined above are very similar to some of the conclusions outlined in Stockopedia’s multibagger research.

The StockRank evolution described above for the winners matches the traits displayed by the multibaggers almost exactly:

Although the study of multibagger returns excluded dividends, all 10 of the top multibaggers in our multibaggers study paid dividends throughout the 10-year period (excluding any pandemic-related disruption).

Indeed, several of our top dividend growth winners also feature among the top 10 multibaggers.

Perhaps this isn’t surprising. I’ve long believed that reliable dividends are an important indicator of successful, disciplined businesses with a focus on shareholder returns – characteristics essential for long-term growth.

To put these ideas into action, I believe investors would do well to focus on small/mid-cap stocks with Super Stock or High Flyer styling and the QM bias I’ve discussed above.

At a fundamental level, I’d be looking for above-average profitability, low debt, good cash conversion from earnings and evidence of a growing and well-covered dividend.

In a follow-up article next week, I’ll take a look at these ideas in more depth and discuss some of the winning dividend growth companies behind the data I’ve discussed in this article.

In the meantime, I’d love to hear your thoughts on this topic below.