Four Key Numbers for analyzing Dividend Growth Stocks
Plus One Great Dividend Growth Stock
I like to say that dividend growth is the income investor’s secret weapon. Most investors think of dividends as moderate payouts from staid stocks. But the best dividends are anything but boring: they can grow by 20% or more per year, every year.
Investors don’t necessarily notice this growth though, because growing dividends are usually accompanied by a rising stock price (long-term). When dividends and price rise together, yield (the percentage of your investment you earn in dividends every year) often stays about the same.
But when you own a stock with a growing dividend, your yield grows year after year. For example, if you bought Coca-Cola (KO) 10 years ago, when it was trading around $25 a share (split-adjusted) and yielding 2%, your yield on cost is now 5.0%. That’s because yield on cost is equal to the annual dividend you’re now receiving, divided by your purchase price. In this case, that’s:
$1.24 / $25 = 4.96%
You can also think of this as your current annual income from the stock divided by your original investment (or cost basis). If you bought 100 shares of Coca-Cola at $25, you’re now receiving $1.24 for each share per year, totaling $124 per year. Divided by your initial investment, that’s a yield of:
$124 / $2,500 = 4.96%
And that’s on an investment made in 2004. Over a longer time frame, dividend growth can be even more powerful. It’s estimated that the dividends generated by Berkshire Hathaway’s position in Coca-Cola now exceed the conglomerate’s initial investment in the company. That’s a yield of over 100%.
So how can you find these stocks that pay you more to own them year after year?
I like to look at four simple traits that suggest a company has both the ability and inclination to pay larger dividends going forward. I have a proprietary ratings system, IRIS, that helps me find these stocks for my Cabot Dividend Investor subscribers, but you can look at these four simple numbers yourself to get a good idea of a stock’s dividend growth potential.
1.) Dividend History. The best dividend growers make increasing dividends a priority in good years and bad, and you can easily check on that by looking at their history of dividend increases. Companies that have increased their dividends every year for many years clearly prioritize dividend growth, and their consistency tells you that they’re in a reliable business that generates consistent income to pass on to investors.
2.) Dividend Growth Rate. The dividend growth rate measures how much a company has increased its dividend each year. Holding stocks that consistently increase their dividends by a significant amount is the best way to secure a growing stream of income. Plus, bigger dividend increases mean that management prioritizes rewarding investors, and that cash flows are growing robustly.
IRIS generates dividend growth rates for the past five and ten years, but you can quickly find them yourself by calculating the compound annual growth rate of the dividend over a given period (using a CAGR calculator or simple math).
3.) Payout Ratio. The payout ratio is equal to a stock’s annual dividend divided by its EPS. This percentage tells you how much of its income the company is paying out to investors versus how much they’re holding back. For example, in 2013, Wal-Mart (WMT) earned $5.02 per share, and paid a $1.59 per share dividend, so its payout ratio was about 32% ($1.59/$5.02).
A low payout ratio is good; it shows that the company’s dividend payments are well covered by its earnings, so they’re not in danger. In addition, it means the company is holding plenty of cash back to reinvest in the business, ensuring the security of future dividend payments.
Conversely, a high payout ratio can be a red flag that a company is having a hard time affording its dividend payments, especially if the payout ratio is historically high for that company. Companies that pay out a large percentage of their cash also have less cash to reinvest in growing their business.
In general, I like to see a payout ratio under 40%, although some companies will be able to sustain higher ratios, and some faster-growing companies should keep theirs lower. (Utilities, REITs, MLPs and some other income investments also have much higher payout ratios.)
4.) Earnings Growth. Dividends are paid out of cash flow, so if cash flow doesn’t grow, dividends can’t grow. In particular, I look at operating cash flow, which is a more “pure” measure of cash coming in than EPS. Dividends are cash payments, after all, so non-cash adjustments to EPS and other accounting tricks don’t affect a company’s ability to pay its dividends.
However, I do consider EPS estimates when evaluating a stock’s dividend growth potential, since they’re forward-looking. Estimates should show EPS growing from year to year, ideally by a double-digit percentage. It can also be helpful to look at the company’s history of EPS growth. Accelerating EPS growth may translate into faster dividend growth in the future.
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My most recent dividend growth recommendation is Reynolds American (RAI). Here’s what I wrote about it in the July issue of Cabot Dividend Investor.
“Reynolds American (RAI) is the second-largest U.S. tobacco company. The company has a long history of prioritizing shareholder returns, and aims to distribute about 80% of net income to shareholders.
“There’s also a growth story here: Reynolds is making major inroads into the e-cigarette market, which is both fast growing and lightly regulated (for now).
“Reynolds has paid dividends since 1999 and has never cut its dividend. The current quarterly dividend of $0.67 per share delivers a generous yield of 4.4% at current prices.
“Reynolds has increased the dividend every year since 2005, at an average rate of about 11% per year, earning the stock a Dividend Growth Rating of 8.45. The Dividend Safety Rating is also in very good territory, at 7.98.
“Reynolds is able to maintain a high payout ratio thanks to its very predictable cash flow. The company aims to distribute 80% of annual consolidated net income to shareholders, and has averaged a payout ratio of about 92% of EPS since 2009. The company’s current payout ratio (based on the past 12 months) is in line with the historical average, at 90%. (While this would be high for many stocks, Reynolds has proven it can grow the business even with the payout ratio at this level.)
“The stock’s rapid four-month advance may be followed by a pullback or a consolidation here. However, the first numbers from the nationwide rollout of its e-cigarette, Vuse, are likely to act as a catalyst for further advancement later this year, as could its Lorillard acquisition.”
Sure enough, the stock encountered a pullback on July 15, and has continued to move lower as investors analyze the results of this mega-merger. RAI is now trading below 57, which looks like a bargain in valuation terms.
And today, Reynolds American reported that its second-quarter earnings rose by 6.7%, topping analysts’ expectations. For continuing guidance on Reynolds American, and more of the best dividend growth stocks in the market, consider trying our newest publication, Cabot Dividend Investor.
Chloe Lutts Jensen
Chief Analyst, Cabot Dividend Investor