The 3 Ways To Grow Your Income With Dividend Stocks

Includes: BP, CL, COP, HSY, JNJ, KO, PEP, PG, RDS.B, XOM
by: Tim McAleenan Jr.

This post is aimed at investors that seek common stocks likely to grow dividends at 7-12% over the long term. As we consider the areas of the economy where these types of stocks are most likely to hide out, we should first keep in mind the three conditions that will determine the company's ability to achieve high dividend growth (the listing of these elements comes courtesy of an academic paper published by Case Study Investing, which you may access by clicking here).

1. The payout ratio. Obviously, if a company has a 100% payout ratio and elects to pay out all of its profits as dividends, there is no room to take the profits and reinvest them for growth. If a company has a low payout ratio, say, 30%, then it can use that other 70% to fund future earnings growth, potentially increasing the future ability of the company to pay dividends.

2. The return on reinvested earnings. The ability of a company to take the capital and earn a high ROIC (return on invested capital) will influence the rate at which future earnings growth (and subsequent dividend growth) will become feasible.

3. The return on existing assets. As Glen Arnold's book, "The Handbook of Corporate Finance: A Business Companion to Financial Markets, Decisions, and Techniques", explains: "[Return on existing assets]… concerns the amount earned on the existing baseline set of assets, that is, those assets available before reinvestment of profits. This category may be affected by a sudden increase or decrease in profitability. If the firm, for example, is engaged in oil exploration and production, and there is a worldwide increase in the price of oil, profitability will rise on existing assets."

When you keep these three factors in mind as you make investments, you can find some good investment opportunities simply by asking yourself the question: "What areas of the economy tend to offer the best combination of attractive payout ratios, high returns on reinvested earnings, and high returns on existing assets?" For me, the immediate answer is: Big Oil and Consumer Staples.

In the case of the large oil companies, the payout ratios are quite low (this is out of longstanding necessity so that if commodity prices fall, the capital expenditures and dividends may continue without a hitch). In the case of Exxon (NYSE:XOM), the$2.28 annual dividend is only 19% of this year's expected cash flow. Chevron's $3.60 annual payout is only 16% of this year's expected cash flow per share. For Conoco Phillips (NYSE:COP), the $2.64 payout is 24% of this year's expected cash flow. Shell's (NYSE:RDS.B) $3.44 payout is 26% of this year's expected cash flow, and BP's (NYSE:BP) $2.16 annual dividend is 23% of this year's expected cash flow.

These low payout ratios across the industry are by design. The general modus operandi for Big Energy is to fire on all three cylinders by paying dividends, buying back the stock to reduce share count, and making significant capital expenditures to fuel future growth. The successful application of this strategy is what permits the industry to offer such high dividend growth: the aggressive buybacks mixed with significant capital expenditures blend together to generate the kind of earnings per share growth that can fund high dividend growth. Unless the price of oil falls by a meaningful amount (greater than 25%), this thesis should hold up reasonably well.

The other place to look for high dividend growth is the consumer staples and discretionaries such as Coca-Cola (NYSE:KO), Pepsi (NYSE:PEP), Colgate-Palmolive (NYSE:CL), Hershey (NYSE:HSY), Procter & Gamble (NYSE:PG), and Johnson & Johnson (NYSE:JNJ). These companies tend to pay out a little bit more than half their profits as dividends, so the future growth does not come from low payout ratios but rather from the high returns on reinvested earnings and returns on existing assets.

Procter & Gamble has a 18.5% return on shareholder equity. Pepsi has a 21% operating margin. Coca-Cola has a 20% return on total capital. Johnson & Johnson has a net profit margin just shy of 22%. Hershey has a return on assets over 15%. Although these companies may not have the low payout ratios to allow for rapid earnings growth to subsequently fund high dividend growth, they are able to deploy profit in such an efficient manner that they can earn the high returns necessary to raise dividends by high single digit (to low double digit) rates over long periods of time.

This list is by no means exhaustive. There are pockets of health care companies out there that can achieve high dividend growth. Likewise, certain utilities and banks have attractive structures that could lead to high dividend growth going forward. The point is that, if you want to look for high dividend growth, you should keep in mind the three conditions that can enable a company to give shareholders meaningful raises: usually a strong combination of a low payout ratio, high returns on reinvested earnings, and high returns on existing assets. If you can find companies that appear attractive by those metrics, you may have found fertile ground for high dividend growth rates over the long term.

Disclosure: I am long BP, JNJ, XOM, COP, PG. 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.