investor clinic

I know you are a fan of companies that raise their dividends. Which is better: a stock with a high dividend that grows at a modest pace, or a stock with a modest dividend that grows at a high pace?

In finance, there’s something called the dividend discount model. Also known as the Gordon growth model, it’s an equation for calculating a stock’s current worth based on all of its expected future dividend payments, discounted back to their present value.

The Gordon growth model – named after the late economist, Myron J. Gordon, who spent many years at the University of Toronto – is relevant here because, if you rearrange the equation, it provides a way to estimate the return of a dividend-paying stock. Specifically, the equation holds that a stock’s annual return should equal the current dividend yield plus the dividend growth rate. For example, a stock that yields 6 per cent, and whose dividend grows at 4 per cent annually, should theoretically return 10 per cent annually, assuming all dividends are reinvested in additional shares.

Similarly, a stock yielding 3 per cent, and whose dividend grows at 7 per cent, should also produce an annualized total return of 10 per cent – at least in theory. Again, this assumes all dividends are reinvested. So, according to the formula, it’s not the yield or dividend growth rate in isolation that matters, but the combination of the two.

As a dividend growth investor, I aim to get the best of both worlds: an above-average yield, and a high dividend growth rate. Many classic dividend-paying companies – such as banks, utilities and telecoms – tick these boxes. (For specific examples, see my model Yield Hog Dividend Growth Portfolio.)

The Gordon growth model is far from perfect. A key assumption of the model in its most basic form is that the dividend will grow at a constant rate, which never happens in real life. The model also assumes that the share price will rise at the same rate as the dividend, which, again, is not necessarily the case.

Stock prices are influenced by myriad factors, including interest rates, inflation, economic growth, market sentiment and company-specific developments. Dividend growth rates can increase or decrease, and in extreme cases dividends can be reduced or eliminated if a company’s outlook changes for the worse. Over the long run, however, a company that pays a solid yield and raises its dividend steadily stands a good chance of producing attractive returns.

Instead of trying to pick one dividend growth stock over another, my advice is to diversify by holding a mix of high-quality dividend growth companies with yields in the 3- to 6-per-cent range, give or take a percentage point. Stocks with yields higher than that require additional investigation, as their dividends may not be sustainable. For added diversification, I also recommend holding exchange-traded funds that track major Canadian and U.S. stock indexes.

If you ignore market volatility and focus instead on collecting your dividends – and reinvesting them to turbocharge your portfolio’s growth – chances are you will make out well in the long run.

In your column last week, you said brokers often provide incorrect adjusted cost base numbers on T5008 Statement of Securities Transactions slips. As such, you advised investors to double-check the figures against their own ACB calculations. What should people do if they find a mistake in their ACB?

After the column appeared, readers shared their own ACB horror stories.

“This year, for the first time, I used the CRA’s ‘auto-fill’ feature and had to strip out all the information from the T5008s, as so much of it was wrong,” one reader wrote. “Incredible how my online broker messes up the impact of stock splits/consolidations on ACB.”

If ACB errors aren’t caught, they can result in incorrect calculations of capital gains and losses when a stock is sold. A chartered accountant told me he is experiencing these mistakes on a regular basis with clients. Not only are the numbers often wrong, but the box for the cost or book value is sometimes left blank, said the accountant.

What should investors do if they find a mistake? The accountant said he simply enters the correct ACB on the client’s return and e-files it to the Canada Revenue Agency.

He said he makes sure the necessary documentation is kept on file in the event of a review.

Investors should also notify their broker of the mistake.

E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.