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Many dividend investors are under the mistaken impression that a company which can pay an increasing dividend each year should be able consistently increase dividends indefinitely. Unfortunately not all dividend increases are created equally.

In order for a company to be able to consistently increase a dividend, it fundamentally needs to grow operating earnings and operating cash flow. An inability to grow either of these over an extended period of time will ultimately impact the ability of a company to increase its dividend to shareholders.

It is still possible for a company to increase its dividend for quite some period of time even though operating earnings growth has stalled. A business can decide that it is going to pay out an increasing amount of its earnings in the form of dividends and just reinvest less in the business. In such a scenario, I view dividend growth as temporary and unlikely to continue over the long term.

There are two reasons increasing the amount paid out in dividends will be ultimately detrimental to dividend growth.

1) A business can only increase its dividend so much in the absence of earnings growth. While a company may not initially pay out all its earnings as dividends, ultimately earnings and cash flow will set a limit to what can be paid as a dividend.

2) By paying out more in earnings to shareholders in the form of dividends, a company is reducing what it can reinvest back into the business. Limiting reinvestment back into the business places curbs on the extent that a company can grow the business over an extended period of time. Longer term earnings growth will ultimately suffer if reinvestment opportunities are passed up in favor of preserving short term dividend growth.

Ultimately companies that continue to increase their dividend without earnings growth or operating cash flow growth will eventually be forced to cut their dividends.

Consider the example of Avon Products (NYSE:AVP). Avon had experienced close to 22 years of dividend growth prior to 2012, before its dividend was drastically cut. Until as recently as even 2011, Avon Products had still been experiencing dividend growth. So then how was this dividend cut possible and should dividend growth investors have seen this coming?

Avon Products earnings per share growth and operating cash flow growth had been in decline for the last few years prior to 2012. While Avon Products earnings per share were $2.04 in 2008, by 2011 earnings per share were only $1.18. Avon Products operating cash flow of $782M in 2009 had also decline to just $656M in 2011. So while earnings per share had declined by close to 40% from 2008 to 2011 and operating cash flow had declined almost 16% from 2009 to 2011, Avon's dividend had grown by almost 15% from 2008 to 2011.

Clearly sustained dividend growth was not going to be possible when the operating performance of the business was in such decline. Avon's payout ratio had also increased from 39.2% in 2008 to 76.7% in 2011.

Where dividend growth is not in line with earnings growth or cash flow growth, any increase in dividends are artificially inflated. Growth in dividends will ultimately fall back in line with operating growth or eventually result in dividend cuts.

Which companies warrant additional investigation for artificial dividend growth?

Waste Management (NYSE:WM)

On the surface, Waste Management looks like they have been delivering solid, sustainable dividend increases. A deeper look at the financials reveals that earnings per share growth and operating cash flow growth have both been minimal in recent years.

With earnings per share of $2.19 in 2008 and at $2.04 in 2011, Waste Management has experienced a decline in earnings per share of 7.4% over the period. Similarly operating cash flow has also failed to exhibit any growth since 2008, declining from $2.57B to $2.47B in 2011, a decline of 4%. Waste Management has been able to increase dividends by some 26% over the 2008-2011 period. It is little surprise that the payout ratio of Waste Management has increased from 49% in 2008 to almost 67% in 2011 to fund this dividend increase.

Johnson & Johnson (NYSE:JNJ)

The last few years of dividends increases at Johnson & Johnson appear to be coming more from an increase in the payout ratio than growth in the operating business.

Johnson & Johnson earnings per share has declined from $4.57 in 2008 to just $3.49 in 2011, a decline of 25%. Similarly operating cash flow has declined from $14.9B in 2008 to $14.2B in 2011, a decline of 4.5%. Over this period, Johnson & Johnson has still managed to increase dividends by some 25%. This increase in dividends has come primarily through an increase in the payout ratio, which went from 39.3% in 2008 to 64.5% in 2011.

While Johnson & Johnson may be going through some operational challenges with patent expiry on some major drugs in its portfolio, it should be pointed out that it is one of a select group of dividend aristocrats that has delivered consistent dividend increases over many years.

Conclusion

Dividend growth that is not driven by earnings growth and operating business performance will eventually slow and stall, leading to possible cuts in dividends. By monitoring advance signals such as earnings per share growth and operating cash flow growth, dividend investors should be able to form a view as to whether future dividend growth is sustainable.

Of course, having a forward looking view on business prospects is also necessary to fully complete the assessment and gain comfort that any slowdown in business earnings is merely a temporary issue and not a permanent problem.

Source: Why Investors Should Be Cautious Of 'Artificial' Dividend Growth