A Closer Look At Dividend Growth Metrics

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Includes: AWR, DOV
by: Chris O'Donnell

Summary

Dividend growth investing relies on making informed predictions about the earnings and dividend stability of a company, many years into the future.

I find that two in-depth metrics help me make better informed investment decisions.

A case study is used to explain these metrics, with the two best dividend growth stocks around today.

In 2014, 85% of the S&P 500 paid a dividend at some point during the year. That's 425 companies, 2% more than the previous year and over 21% more than in 2002. Many more companies outside this index reward shareholders with a consistent yearly payout - some much more than others. People with a DGI (Dividend Growth Investing) focus have a variety of tools with which to tackle this growing heap of companies and choose the ones that fit their situation best. The most common tools include dividend yield, average yearly growth, payout ratio, and consecutive years of dividend raises, among others depending on the specifics of the situation. My favorite way to sift through companies of this genre is to look at David Fish's routinely updated list of dividend Challengers, Contenders, and Champions, which has the tools listed above for over 700 companies that fit the list's criteria. Definitely a must-have for any sort of DGI research.

Since using this list to help complete my due diligence on a dividend growth stock, I've consistently found that I reach for two additional pieces of data before having a full picture of a company's dividend situation. These two inputs aren't included on the Dividend CCC list - I'd love it if they were added on in some sub-version of it in the future. This article explains the 2 things I look at apart from information on the Dividend CCC list when making an investment decision, along with examples that support why I like using these approaches.

The Match-Up: Dover Corp. vs. American States Water Company

To explain why I love adding two new layers of data to the CCC list, I'm going to use the 2 longest-running dividend raisers in existence as a case study: Dover Corporation (NYSE:DOV) and American States Water Company (NYSE:AWR). These companies have raised their dividends for 60 and 59 consecutive years, respectively. Before I go on, can we just take a minute and marvel at that achievement? Dwight D. Eisenhower was President the last time these companies didn't raise their dividends - pretty amazing if you ask me.

How should we as investors choose between these two names if we wanted to take part in their dividend growth stories? We already know that each company's management is highly committed to paying (and raising) their dividends by their inclusion on the CCC list, especially as Champions. Both companies currently support similar yields (AWR's 2.4% yield barely edges out DOV's payout of 2.20%), and have been raising distributions for very similar amounts of time. Differences between the two names come when looking at average dividend growth over the past 10 years - DOV's growth of 11.8% per year almost doubles AWR's growth rate of 6.5%. Sectors also play a role in dividing how these stocks will suit investors in terms of diversification, with DOV operating in the industrial space and AWR gravitating towards the utility allocation of a portfolio. In terms of this case study, we won't focus on each company's sector until later on.

With this basic information in mind, we can already make some quick judgements and see that, at least on their face value, Dover will serve DGI-ers better over the long term. This is because of the magic that defines what a dividend growth investor inherently bases their decisions on: dividend growth. If DOV raises its dividend at a faster clip than AWR, then DOV should make me more money in the future, which compounding should only magnify as time goes on, right?

Bingo. The chart above is a simulation of what $1,000 invested in either company today would be worth over the next 20 years, assuming historical dividend growth trends continue on their current trajectory, and ignoring any price action. These projections take into account 11.8% dividend growth for Dover and 6.5% growth for American States Water, as well as the reinvestment of all dividends to capture the power of compounding. The long-term results speak for themselves: After 20 years, a $1,000 investment in DOV would be worth over $4,500 if left untouched, versus just under $2,500 if invested in AWR. DOV's projected annual return of 17.8% per year crushes AWR's return of 7.1%, which shows a 500 basis point growth difference can mean a massive performance gap once time does its work.

With this information, the answer seems clear. Place a market order for Dover at the open tomorrow, sit back, relax, get rich. Easy as 1, 2, 3. Dividend growth is the end-all trump card when looking at the most consecutive names in the space, and should be the main basis for any investment decisions of this type, right?

Interestingly enough, American States Water doesn't lag as far behind Dover as the chart above would have you believe. In some cases, I might even choose AWR as the winner, and my reasoning is two-fold: AWR's dividend safety is on par with DOV when looking at their respective dividend ceilings, and AWR's payout ratio is trending lower, which means a higher rate of dividend growth is more likely in the future. Let me explain further:

The Dividend Ceiling: A Blend of Growth and Pay-Ability

How on earth could American States Water's dividend growth be anywhere close to Dover when I projected an investment in DOV to be worth twice as much in 20 years? Part of the answer lies in the dividend ceiling, a metric I use to assess the worst-case scenario for a company in terms of its ability to continue raising its dividend. Most use the payout ratio, which acts as a snapshot of the amount of earnings being distributed as dividends to shareholders. DOV's payout ratio? 32% - close to one third of earnings used to cover the dividend. AWR's ratio? 53%. Generally, the lower the payout ratio, the better, because a company with a low ratio has more earnings power to allocate to its dividend, and has more flexibility to reward shareholders in the future. A glance at the payout ratio would tack another point in Dover's favor on first look, but this doesn't tell the whole story.

The dividend ceiling is a different metric than the payout ratio, because it takes into account a company's dividend growth and its future effect on earnings. Let's look at Dover's ceiling as an example. Dover has achieved 11.8% yearly dividend growth over the last 10 years, so I will assume for now that this can be replicated into the future. With this growth projected into upcoming years, I'm predicting DOV's dividend to be $1.79 by 2016, $2.00 by 2017, and so on and so forth. The question I want the dividend ceiling to answer is: if Dover's earnings showed no growth in the future, how much longer could it raise its dividend before earnings were no longer able to cover it? This would be a worst-case scenario, and should let investors know what to expect should Dover's business run into particularly hard times. If we continue to project current dividend growth into the future, we should get to year 10 before dividends reach earnings (projected dividends at year 10 = $4.88, current EPS = $4.95). At current earnings and dividend growth, Dover's dividend ceiling is 10 years - a fairly large cushion to continue raising its dividend and get business fundamentals back on track should earnings growth end entirely.

Applying the same calculations to American States Water, we see that its dividend ceiling is also equal to 10. Even with a higher payout ratio, AWR's slower rate of dividend growth gives it the same amount of cushion as Dover to grow earnings before it's backed into a corner. I think it's helpful to see these growth trajectories play out to get a deeper grasp of what time will do to a DGI holding - it's much more profitable to do the in-depth research now than to realize a mistake some years down the road and miss out on many multiples of growth in a retirement or other investment account.

Going back to our simulation, let's include the dividend ceiling to see where our two projected investments stack up when the dividend ceiling is reached:

With year 10 highlighted in red, a new comparison comes into focus - Dover's impressive payouts are largely muted in the near term, considering most of the separation between the two companies comes at the end of the 20-year scenario. When taking into account current earnings and meshing it with dividend growth, AWR doesn't seem like such a laggard now, does it? Sure, DOV still comes out on top, but the difference is minimal enough to be within the margin of error considering future dividend and earnings projections are quite rigid.

Adding Earnings Growth to the Mix

Now, I can already hear rebuttals to my point above. The dividend ceiling is necessary, sure, but it's too conservative of a metric - do you really expect DOV or AWR to suddenly hit a brick wall as companies and not grow earnings by a single penny in the future? My answer would be most likely no. Both Dover and American States Water have shown exceptional earnings power over the last 10 years, which has fueled the continuation of record-breaking dividend consistency and growth. Historical EPS growth is shown below:

AWR EPS Diluted (<a href=

AWR EPS Diluted (TTM) data by YCharts

This 10-year performance of these companies, combined with a dividend history spanning 60 years, gives me confidence in the viability of future earnings growth. Let me not get ahead of myself; however, past earnings performance never implies a continuation of the trend, which is where investors need to tailor their research for their own situation. If earnings are conservatively projected, investors will make very different decisions concerning my next point than if the earnings picture is more optimistic. Take these numbers with your personal situation in mind.

The next point I use to assess a dividend growth stock is its earnings trend, and how that trend is affecting the strength of its dividend. This means assessing a company's payout ratio over many different points in time to find a pattern. Taking the payout ratio and assessing its trajectory gives me a much clearer picture of a company's financial health, instead of looking at just one single snapshot in time. Let's apply this to our scenario:

AWR Payout Ratio Chart

AWR Payout Ratio (TTM) data by YCharts

As shown above, AWR's payout ratio has dropped significantly over the past decade while Dover's ratio has steadily risen. Using this information, I can make predictions about the future ability of these companies to increase or decrease their level of dividend growth.

For example, since Dover's dividend has grown at a faster pace than earnings have in the past, I know that either earnings need to accelerate or dividend growth will stall. Until either of these things happens, DOV's payout ratio will continue to rise, which doesn't bode well for the business. If a greater share of the earnings pie has to be dished out in the form of dividends, less money is left over to expand the company and drive future earnings. As an investor, I want to see this trend correct itself before I can feel confident that Dover can continue its recent pace of shareholder rewards. Until then, I would be cautious.

American States Water, on the other hand, has a high likelihood of accelerating dividend growth in the future. This is because its payout ratio has trended lower for years now, and is predicted to go lower still in the future. This means that AWR is growing earnings at a faster rate than dividends, which frees up money for either more distributions in the future or other business projects as seen fit. If current earnings growth were to continue for these two companies, AWR would have a lower payout ratio than DOV by year 11, meaning the company should increase its dividend growth rate at some point down the road. It certainly has the capacity to if earnings stay this strong.

Again, this all comes back to earnings predictions and how that affects these ratios. This is where sectors become a factor, too. Dover may be able to keep up its earnings pace in an economic expansion because it's more of an industrial company while American States Water may have a hard time keeping earnings growing at its current pace, being a slow-but-steady water and power utility. Even with these classifications in mind, AWR has been growing enough over the past decade to warrant a higher rate of dividend increases, which will change how an investment in the name will perform.

Conclusion

This case study aimed to uncover two main points:

  1. One - high dividend growth doesn't mean that much if earnings can't cover them in the future, and
  2. two - the payout ratio is less useful as a single point in time, and should be taken as a trend over many years to get a feel for the future of a company's dividend sustainability.

These metrics are useful to me, and I hope they can be of some use to you too. If you think that these ratios may be a bit of overkill, I would like to think that it is better to have too many points of information when making an investment decision than too few - especially when it comes to dividend growth investing, simply because the power of this style comes after many, many years of compounding have taken place. Thank you for reading and commenting!

Disclosure: I/we 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.