Dividend growth investing can work wonders over the lifetime of an investor's portfolio. However, the problem facing dividend-growth investors is that the lifetime of the portfolio can be decades at times. So how can investors find stocks that are the most likely to continue raising their dividends over time? We use our Valuentum Dividend Cushion to identify three below.
We like to keep things simple. Dividends are paid in cash, not earnings. As we know, earnings are an accounting measure and can vary quite significantly, particularly if a company needs to take an accounting charge. However, cash is cash. And we think firms that have excellent balance sheets (think large current cash positions) and generate a lot of free cash flow (CFO less capex) relative to their current dividend payments (check a firm's cash flow statement) are the ones that are best-positioned to sustain and raise their dividends in the coming decades. Though we think the payout ratio is important, we think cash-based analysis is even more informative. For example, please view how cash-flow based analysis predicted SuperValu's (NYSE:SVU) dividend cut in this article here.
Furthermore, we're interested in whether a company will continue raising its dividends in the future, not what it has done in the past. Although analyzing historical trends is important, the S&P 500 Dividend Aristocrat List, or a grouping of firms that have raised their dividends for the past 25 years, is a great example of why backward-looking analysis can be painful. Based on our proprietary (yet fully transparent) Valuentum Dividend Cushion measure (which we make available for all firms in our coverage), below are three companies that are in an excellent position to raise their dividends (distributions) into the future. A score that is comfortably above 1 on the Dividend Cushion indicates that a company can cover future expected dividends based on its balance sheet and cash-flow profile.
Current Annual Yield: 2.6%
Valuentum Dividend Cushion: 2.5
We like 3M's business-segment/geographic diversification and its track record of continuous innovation. We assess the safety of its dividend by adding the company's net cash to our forecast of its free cash flows over the next five years. We then divide that sum by the total expected dividends over the next five years. This process results in our Dividend Cushion™ ratio. A Dividend Cushion™ above 1 indicates a firm can cover its future dividends with net cash on hand and future free cash flow, while a score below 1 signals trouble may be on the horizon. And by extension, the greater the score, the safer the dividend, as excess cash can be used to offset any unexpected earnings shortfall. 3M scores a 2.5 on our Dividend Cushion™, which is good.
Current Annual Yield: 3.5%
Valuentum Dividend Cushion: 1.7
McDonald's is facing fierce competition on almost every front, and we think sales weakness could persist in the near term. However, international performance will likely be stronger in 2013, and we would not be surprised to see customers return to McDonald's after trying all of the new offerings at Wendy's (NYSE:WEN) and Burger King (BKW). In fact, McDonald's stands out to us as one of the better income plays on the market today, and we are strongly evaluating it for our dividend growth portfolio. We judge the future potential growth of the company's dividend by evaluating the capacity for future increases, as measured by the Dividend Cushion™, and management's willingness to consistently raise the dividend, as measured by the firm's dividend track record. McDonald's registers an excellent rating on our growth scale, and we think the firm's annual dividend will be $3.74 per share within the next several years.
Current Annual Yield: 3.5%
Valuentum Dividend Cushion: 1.3
Sysco is the largest North American distributor of food and related products primarily to the foodservice and restaurant industry. We're huge fans of its expansive distribution network, which would be incredibly difficult for new entrants to replicate. We assess the safety of the firm's dividend by adding the company's net cash to our forecast of its free cash flows over the next five years. We then divide that sum by the total expected dividends over the next five years. This process results in our Dividend Cushion™ ratio. A Dividend Cushion™ above 1 indicates a firm can cover its future dividends with net cash on hand and future free cash flow, while a score below 1 signals trouble may be on the horizon. By extension, the greater the score, the safer the dividend, as excess cash can be used to offset any unexpected earnings shortfall. Sysco scores a 1.3 on our Dividend Cushion™, which may not be as strong as firms in our dividend growth portfolio but still is good.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.