Dividend growth investing can work wonders over the lifetime of an investor's portfolio. The problem facing dividend-growth investors, however, 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?
At Valuentum, 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 gobs 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. In fact, one only has to look over the past few years to see the removal of such big names from the Dividend Aristocrat List like General Electric (NYSE:GE) and Pfizer (NYSE:PFE) to understand that backward-looking analysis is hardly worth your time.
After all, you're investing for the future, so the future is all you should care about. We want to find the stocks that will increase their dividends for 25 years into the future, not use a rear-view mirror to build a portfolio of names that may already be past their prime dividend growth years. It simply takes decades to build wealth through dividend growth investing, and a dividend cut or two in the out-years could potentially devastate one's income portfolio.
Based on our proprietary (yet fully transparent) Valuentum Dividend Cushion measure (which we make available for all firms in our coverage), below are 5 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.
Kinder Morgan Partners (NYSE:KMP)
Current Annual Yield: 5.9%
Valuentum Dividend Cushion: 1.4
Dividend Growth Newsletter portfolio holding Kinder Morgan Partners recently reported third quarter results. Revenue grew 10% year-over-year to $2.3 billion, which was slightly better than consensus expectations. Net income per unit, when excluding special items, surged 30% year-over-year to $0.57, roughly in-line with consensus estimates. More importantly, distributable cash flow per unit grew nearly 8% year-over-year to $1.28, and the firm subsequently raised its distribution for the quarter to $1.26. Year-to-date, the firm has accumulated $3.72 per unit versus a payout of $3.69, leaving the company with $8 million of distribution coverage year-to-date. The firm continues to forecast an annual payout of $4.98 per unit, but it now expects to have some cushion, which it did not previously anticipate. We emphasize, however, that our Valuentum Dividend Cushion score on Kinder Morgan requires the healthy functioning of the capital markets, as we expect future unit issuance.
Current Annual Yield: 4.6%
Valuentum Dividend Cushion: 2
We assess the safety of a 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. And by extension, the greater the score, the safer the dividend, as excess cash can be used to offset any unexpected earnings shortfall. Verizon scores a 2 on our Dividend Cushion™, which is good.
Current Annual Yield: 4%
Valuentum Dividend Cushion: 1.6
Hasbro's third quarter was solid, and the decline in toys that market participants have been expecting since the creation of Super Nintendo (years and years ago) continues to overblown, in our view. We judge the future potential growth of the 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. Hasbro registers an excellent rating on our scale, and we think the firm's annual dividend will be $2.24 per share within the next several years.
Johnson & Johnson (NYSE:JNJ)
Current Annual Yield: 3.4%
Valuentum Dividend Cushion: 2.6
Dividend growth gem Johnson & Johnson posted strong quarterly results recently. Revenue grew 6.5% (10.8% ex-currency) year-over-year to $17.1 billion, slightly better than consensus estimates. Earnings, net of a non-cash charge of $553 million, increased 0.8% year-over-year to $1.25 per share, a few cents better than consensus expectations. The company raised its full-year adjusted earnings forecast to $5.05-$5.10 per share, above its previous guidance of $5.00-$5.07 per share and roughly in-line with the consensus estimate of $5.06 (the midpoint was better, however). We expect the Synthes acquisition to be accretive to earnings in 2013, and we believe the company will continue to generate copious amounts of cash flow going forward. We like the company, and we hold shares in our Dividend Growth Newsletter portfolio.
General Dynamics (NYSE:GD)
Current Annual Yield: 3.2%
Valuentum Dividend Cushion: 2.5
We judge the future potential growth of the 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. General Dynamics registers an excellent rating on our scale, and we think the firm's annual dividend will be $2.85 per share within the next several years.
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.
Additional disclosure: Some of the firms mentioned in this article may be included in our actively-managed portfolios.