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This is Part III of a three-part series on the importance of Return on Invested Capital (ROIC) as a fundamental analysis tool. Part I is here and Part II is here. While the first two articles focus on the utility sector and dividend yield, this article will expand to include all sectors and will review the concept of dividend growth investing, of which utilities are included.

The origins of dividend growth are simple - expanding company profits and giving back to shareholders some of those higher profits in the form of higher dividends. It is easy to develop a spreadsheet with historical dividend growth data. It is also easy to develop the same data for firms that have been identified as long-term dividend growers, such as those known as Dividend Champions. Mr. Dave Fish, a SA contributor, offers very meaningful articles about Dividend Champions, such as this one. Mr. Fish also has identified Dividend Contenders and Dividend Challengers. Dividend Champions are classified as those companies that have increased dividends every year for the previous 25 years or longer. It would be safe to make the assumption that if a company has increased its dividend every year for the past quarter century, the trend will continue. The table below lists most of the Dividend Champions sorted by 5-year average annual dividend increase, as reported by Mr. Fish (kudos to his consistent hard work for dividend investors):

Firm

Sybl

Div 5-Yr Growth Annual %

Walgreen Company

WAG

23.70

Target Corp.

TGT

20.50

Nucor Corp.

NUE

18.30

Lowe's Companies

LOW

18.20

Medtronic Inc.

MDT

16.50

Parker-Hannifin Corp.

PH

16.20

T. Rowe Price Group

TROW

14.90

Altria Group Inc.

MO

14.30

Raven Industries

RAVN

14.00

Family Dollar Stores

FDO

13.30

Donaldson Company

DCI

13.00

Franklin Resources

BEN

12.90

Colgate-Palmolive Co.

CL

11.80

Sigma-Aldrich Corp.

SIAL

11.70

Automatic Data Proc.

ADP

11.40

Air Products & Chem.

APD

11.10

AFLAC Inc.

AFL

10.90

Clarcor Inc.

CLC

10.70

Illinois Tool Works

ITW

9.90

ExxonMobil Corp.

XOM

9.70

Nordson Corp.

NDSN

9.50

PepsiCo Inc.

PEP

9.30

McCormick & Co.

MKC

9.20

Helmerich & Payne Inc.

HP

9.20

Valspar Corp.

VAL

9.00

Eaton Vance Corp.

EV

8.90

Archer Daniels Midland

ADM

8.80

Coca-Cola Company

KO

8.40

RLI Corp.

RLI

8.40

Emerson Electric

EMR

8.20

Stanley Black & Decker

SWK

8.10

UGI Corp.

UGI

8.00

Pentair Ltd.

PNR

8.00

Tennant Company

TNC

7.50

Sysco Corp.

SYY

7.30

Stepan Company

SCL

7.10

Kimberly-Clark Corp.

KMB

7.00

VF Corp.

VFC

6.30

Carlisle Companies

CSL

6.30

Genuine Parts Co.

GPC

6.20

Lancaster Colony Corp.

LANC

6.00

Mine Safety Appliances

MSA

5.50

Telephone & Data Sys.

TDS

4.70

McGraw-Hill Companies

MHP

4.50

Sherwin-Williams Co.

SHW

4.40

3M Company

MMM

4.20

Commerce Bancshares

CBSH

3.50

National Fuel Gas

NFG

3.40

Mercury General Corp.

MCY

3.30

1st Source Corp.

SRCE

3.30

Sonoco Products Co.

SON

3.10

WGL Holdings Inc.

WGL

3.10

Community Trust Banc.

CTBI

2.90

Cincinnati Financial

CINF

2.90

Tootsie Roll Industries

TR

2.80

Old Republic International

ORI

2.40

Universal Corp.

UVV

2.20

United Bankshares Inc.

UBSI

2.10

Conn. Water Service

CTWS

2.10

MGE Energy Inc.

MGEE

2.00

Vectren Corp.

VVC

2.00

California Water Service

CWT

1.70

Atmos Energy

ATO

1.50

Middlesex Water Co.

MSEX

1.40

Consolidated Edison

ED

0.80

Walgreens (WAG), Target (TGT), Nucor (NUE), and Lowe's (LOW) would seem obvious investment choices based on 5-year dividend growth data. With inflation running at about 2.5%, buying into a stock with a 5-year average dividend increase that is several times the inflation rate should certainly provide a positive real rate of return on that income stream.

Dividend growth investors are usually longer-term "buy and hold" focused in order to achieve the benefits of increasing income over time. However, how does an investor know if past dividend increases are sustainable?

Enter the concept of return on invested capital analysis. Many investors give more weight to current yield and historical dividend increases than ROIC. This could be a fundamental mistake, as it does not consider sustainability, and successful dividend investing depends on sustainability of the income stream.

Return on invested capital is similar to the more popular Return on Equity (ROE) as it calculates management effectiveness in creating shareholder value. The benefit of ROIC is it incorporates both debt and equity where ROE only evaluates returns based on equity. This subtle difference is especially critical in industries that are capital intensive, such as utilities. However, the usefulness of ROIC goes beyond utilities.

For instance, Parker Hannifin (PH) has a 5-year average ROE of 17.49% while Altria (MO) clocks in with a ROE of 66.50%. PH and MO offer a 5-year dividend growth rate of 16.2% and 14.3%, respectively. It could be safe to assume that MO could be a better choice as its ROE is almost four times higher than PH and should better support future dividend growth. However, MO carries a debt-to-equity ratio of 3.89 while PH carries a debt-to-equity ratio of 0.38. When all capital deployed is considered, MO's "advantage" disappears as PH management has generated a 5-year average annual ROIC of 12.67% vs MO's 13.60%.

If dividend growth is dependent on management's ability to generate shareholder returns and if ROIC becomes the preferred measuring stick of profitability, how could ROIC assist in determining the sustainability of historical dividend increases?

Comparing management's ability to generate long-term profitability based on all capital deployed to the firm's history of dividend increases may create a tool that investors could easily use to evaluate sustainability. For example, if a company generates 5-year average ROIC returns in excess of dividend increases, it could be assumed that management earned returns that not only covered the increases but also added additional capital to the balance sheet. The opposite could be true as well. If a company did not generate 5-year average ROIC that exceeded its dividend increases, the amount of capital earned by management did not keep up with the higher amount paid out to shareholders, and the payout ratio probably increased. An increasing payout ratio may be a red flag over time.

Reworking the above table to compare 5-year average annual dividend increases with 5-year average annual ROIC would look like this, sorted from the largest difference to the smallest:

Firm

Sybl

5-Yr Div Growth %

5-Yr ROIC %

Difference

Colgate-Palmolive Co.

CL

11.8

29.9

18.1

3M Company

MMM

4.2

21.6

17.4

Lancaster Colony Corp.

LANC

6.0

20.0

14.0

Raven Industries

RAVN

14.0

27.5

13.5

Sherwin-Williams Co.

SHW

4.4

16.6

12.2

Automatic Data Proc.

ADP

11.4

23.0

11.6

Sysco Corp.

SYY

7.3

17.8

10.5

Eaton Vance Corp.

EV

8.9

19.1

10.2

ExxonMobil Corp.

XOM

9.7

17.8

8.1

Stepan Company

SCL

7.1

14.9

7.8

Universal Corp.

UVV

2.2

9.5

7.3

VF Corp.

VFC

6.3

13.2

6.9

Sigma-Aldrich Corp.

SIAL

11.7

18.6

6.9

Kimberly-Clark Corp.

KMB

7.0

13.7

6.7

Donaldson Company

DCI

13.0

19.6

6.6

Coca-Cola Company

KO

8.4

15.0

6.6

Emerson Electric

EMR

8.2

14.7

6.5

T. Rowe Price Group

TROW

14.9

21.0

6.1

McCormick & Co.

MKC

9.2

14.5

5.3

Helmerich & Payne Inc.

HP

9.2

14.2

5.0

MGE Energy Inc.

MGEE

2.0

6.9

4.9

PepsiCo Inc.

PEP

9.3

14.2

4.9

Sonoco Products Co.

SON

3.1

7.8

4.7

Tootsie Roll Industries

TR

2.8

7.3

4.5

Genuine Parts Co.

GPC

6.2

10.7

4.5

Family Dollar Stores

FDO

13.3

17.7

4.4

AFLAC Inc.

AFL

10.9

15.0

4.1

Commerce Bancshares

CBSH

3.5

7.6

4.1

Consolidated Edison

ED

0.8

4.8

4.0

United Bankshares Inc.

UBSI

2.1

6.0

3.9

RLI Corp.

RLI

8.4

12.1

3.7

Mine Safety Appliances

MSA

5.5

9.1

3.6

Community Trust Banc.

CTBI

2.9

6.4

3.5

Cincinnati Financial

CINF

2.9

6.4

3.5

National Fuel Gas

NFG

3.4

6.8

3.4

Mercury General Corp.

MCY

3.3

6.6

3.3

WGL Holdings Inc.

WGL

3.1

6.2

3.1

Clarcor Inc.

CLC

10.7

13.7

3.0

Middlesex Water Co.

MSEX

1.4

4.2

2.8

Illinois Tool Works

ITW

9.9

12.6

2.7

California Water Service

CWT

1.7

4.3

2.6

Conn. Water Service

CTWS

2.1

4.7

2.6

Franklin Resources

BEN

12.9

15.4

2.5

Atmos Energy

ATO

1.5

4.0

2.5

Carlisle Companies

CSL

6.3

8.7

2.4

Vectren Corp.

VVC

2.0

4.4

2.4

Nordson Corp.

NDSN

9.5

11.6

2.1

1st Source Corp.

SRCE

3.3

5.1

1.8

Tennant Company

TNC

7.5

7.6

0.1

Altria Group Inc.

MO

14.3

13.6

-0.7

Air Products & Chem.

APD

11.1

9.1

-2.0

Telephone & Data Sys.

TDS

4.7

2.6

-2.1

UGI Corp.

UGI

8.0

5.1

-2.9

Parker-Hannifin Corp.

PH

16.2

12.7

-3.5

Stanley Black & Decker

SWK

8.1

4.3

-3.8

Medtronic Inc.

MDT

16.5

12.1

-4.4

Valspar Corp.

VAL

9.0

4.6

-4.4

McGraw-Hill Companies

MHP

4.5

0.0

-4.5

Pentair Ltd.

PNR

8.0

2.6

-5.4

Old Republic International

ORI

2.4

-3.7

-6.1

Archer Daniels Midland

ADM

8.8

0.0

-8.8

Lowe's Companies

LOW

18.2

6.7

-11.5

Target Corp.

TGT

20.5

8.6

-11.9

Walgreen Company

WAG

23.7

11.6

-12.1

Nucor Corp.

NUE

18.3

5.4

-12.9

While those at the bottom of the list, NUE, WAG, TGT, LOW, and Archer Daniels Midland (ADM), may not be on the verge of dividend cuts or freezes, it would be safe to assume that their historical dividend increase percentages may be in jeopardy. WAG cannot continue indefinitely to increase its dividend faster than its ROIC.

Those firms at the top of the list, Colgate-Palmolive (CL), 3M (MMM), Lancaster Colony (LANC) and Raven Industries (RAVN), have a 5-year history of generating higher returns than their dividend increases. These firms could be considered to have an improved margin of safety regarding potential dividend increases going forward. Keep in mind, both the top and the bottom firms on the list have a strong history of higher dividends that should remain intact.

One more consideration for investors should be to look at the trend in ROIC. It is easy to compare trailing 12-month (TTM) ROIC with 5-year averages to evaluate a short-term trend. The best of all worlds would be for the TTM ROIC to exceed both the dividend increase and the 5-year ROIC average.

In my opinion, long-term dividend investing is about both dividend growth and its sustainability. Just reviewing 5-year increases in income and current income yield fails to consider a margin of safety for continuation, even for those firms with a rich history of such. The key benefit of increasing dividends as an investment goal is the sustainability of the growth. ROIC is the singular tool that will help investors determine sustainability.

Author's Note: Please review important disclaimer in author's profile.

Source: Forget Dividend Growth Investing, It's ROIC Investing