With interest rates stuck near record lows for the foreseeable future, more and more investors are looking at dividend stocks for income.
But beware the siren call of high-yielding stocks.
A high single-digit or low double-digit yield may look attractive at first glance, but yields that fat are rarely sustainable. Keep in mind that equity investors take a back seat to bondholders and preferred stockholders in the capital structure hierarchy. So that dividend check is no guarantee.
If times get tough and a company becomes strapped for cash, checks to bondholders will get sent out before that dividend check. That's why it's not uncommon to see high-yielding stocks slash or suspend their dividends during economic slowdowns. One only needs to look at investors who picked up shares of General Motors (NYSE:GM) or any of the "stable" bank stocks back in 2008 because of their alluring yields to realize that juicy dividends often don't last.
If you plan on holding onto a stock for a while, it's important to not only look at its current yield, but consider its dividend growth potential too. There are several metrics to consider when determining a company's dividend growth potential.
One of the best measures is the payout ratio. The payout ratio is simply the percentage of net income a company pays out to shareholders in dividends:
Dividends / Net Income
Even better - go to the company's statement of cash flows and look at the percentage of dividends paid to its free cash flow, which is just cash from operations less capital expenditures.
Knowing a company's dividend payout ratio is vital. Typically the higher the payout ratio, the less room a company has to raise its dividend in the future. And if a company becomes distressed, a high payout ratio can signal a significant cut is on the way.
A company with a relatively low ratio of dividends to free cash flow, on the other hand, may just have some big dividend hikes on the horizon. This is typical of a younger, fast-growing company, assuming it even pays a dividend at all. As the company grows and matures, however, it will have less growth opportunities and will usually plow back less cash into the company and more into your wallet.
That means a decent dividend yield today could become a huge yield in the future. For instance, a company that raises its dividend an average of 12% per year will double its dividend every 6 years. And at 18%, it will double every 4 years.
Consider an example. Fictional XYZ Corp. makes widgets. It trades for $50 per share and currently pays a dividend of $1.25 for a yield of 2.5%. It earned $3.75 per share this year, so its payout ratio is currently 33%. You decide to buy some shares today.
Let's assume that over the next 10 years, XYZ sees its earnings growth slow linearly from 15% per year to 7% per year. At the end of 10 years, it will be earning $9.57 per share. Because of the slowing growth, the company decided to increase its payout ratio each year too. By the end of year 10, the company is paying out 67% of its earnings in the form of dividends. This equates to a dividend of $6.38 per share, or a whopping 12.8% yield on your original cost! This ignores any capital gains you might have, too.
Clearly, a company's dividend growth potential is very important for long-term investors.
Sustainable Growth Rate
If a company is going to increase its dividend substantially over time, however, it obviously needs to grow earnings and cash flow to do so. This is why the sustainable growth rate of a firm is so important. The sustainable growth rate is the maximum growth rate that a company can sustain without having to issue more debt or more equity. It is calculated as:
(1 - Payout Ratio) x Return on Equity
For example, say a company pays out 30% of its earnings in dividends and its ROE is 15%. Its sustainable growth rate would be 10.5% (.70 x .15). This is approximately how much the company could grow its earnings using internally generated cash. If the company wants to grow earnings faster than this, it would need to take on more debt or issue more shares. Clearly the lower the payout ratio and higher the ROE, the higher the sustainable growth rate. And a higher sustainable growth rate means higher future cash flow growth and, usually, higher future dividend growth.
This is another reason you should favor lower payout ratios when focusing on long-term dividend growth. The more cash a company currently pays out to its shareholders, the less it has to fund growth without either issuing more debt or more equity. And that means lower long-term earnings growth, and smaller future dividend increases too.
4 Stocks with High Dividend Growth Potential
So what are some stocks with strong long-term dividend growth potential? I have listed 4 stocks below that I think are good candidates. The each have solid current yields, a history of strong dividend increases, relatively low payout ratios and high sustainable growth rates.
Baxter International (NYSE:BAX)
Current Dividend Yield: 2.5%
5-year Dividend Growth Rate: 15.6%
Trailing 12-month (TTM) Free Cash Flow (FCF) Payout Ratio: 41.3%
5-year Average Return on Equity (ROE): 30.5%
Sustainable Growth Rate: 17.9%
Church & Dwight Company (NYSE:CHD)
Current Dividend Yield: 1.8%
5-year Dividend Growth Rate: 47.6%
FCF Payout Ratio (TTM): 29.9%
5-year Average ROE: 16.3%
Sustainable Growth Rate: 11.4%
Microsoft Corporation (NASDAQ:MSFT)
Current Dividend Yield: 3.3%
5-year Dividend Growth Rate: 15.9%
FCF Payout Ratio (Trailing 6 Months): 30.8%
5-year Average ROE: 41.4%
Sustainable Growth Rate: 28.7%
Wal-Mart Stores (NYSE:WMT)
Current Dividend Yield: 2.5%
5-year Dividend Growth Rate: 14.6%
FCF Payout Ratio (TTM): 42.2%
5-year Average ROE: 22.2%
Sustainable Growth Rate: 12.8%
The Bottom Line
In this era of ultra-low interest rates, dividends stocks offer investors attractive income potential. Just remember to be leery of those alluring yields. If you have a long time horizon and plan to hold for years or even decades, look beyond the current dividend yield and consider the dividend growth potential.