One of the most misunderstood concepts of dividend investing is dividend yield. It typically takes a part of almost every dividend investors decision-making process when evaluating an income investment. Investors who typically purchase a stock just for the current yield could get disappointed down the road.
The reason is that once investors purchase shares in a company, current yield stops being relevant for them unless they decide to invest new money in the position. By purchasing shares, they have effectively managed to lock in the current yield. Their future dividend income is therefore dependent not on the dividend yield, but on the dividend payment that the security distributes.
In essence, before initiating a position, investors should evaluate the sustainability of its income stream. Common methods include dividend payout ratio, which measures the proportionate amount of earnings that is distributed to shareholders in the form of dividends. In most industries such as consumer staples for example, a dividend payout ratio below 50% indicates that the dividend payment is sustainable.
In other industries such as real estate investment trusts, funds from operations payout is used in order to evaluate the sustainability of the dividend payout.
Investors should then delve deeper in order to understand how the company makes money. Reading the annual and quarterly reports on the SEC website, as well as press releases, stock research reports and news on the security is a must in order to understand the business. Investors should look for some sort of a competitive advantage that differentiates the investment from competitors. For example, Wal-Mart Stores (NYSE:WMT) offers the lowest retail prices to consumers. The company has invested a significant amount of capital in improving its management of inventory and purchasing. Due to its sheer scale of operations, it commands lower prices from suppliers and generates efficiencies from distribution and administrative functions. This has allowed WMT to bring the lowest prices to consumers. Check my analysis of the stock.
Next, investors should evaluate whether the companies analyzed would be able to generate higher earnings over time. Only companies that can generate higher earnings will be able to increase dividend payments. Otherwise, anyone can compile a portfolio of stocks which have a high current yield. What is important for investors is not only how much this portfolio pays today, but also whether it would be able to at least maintain purchasing power in the future. Smart investors who purchased carefully researched dividend growth stocks, that offer potential for dividend increases above the rate of inflation and were priced attractively at the time of purchase, have a high chance of creating a long lasting dividend producing portfolio.
Five companies who are currently building higher future yields include:
McDonald’s Corporation (NYSE:MCD), together with its subsidiaries, operates as a food service retailer worldwide. The company has raised dividends for 35 years in a row, and has a ten year dividend growth rate of 26.50% per year. Yield: 2.80% (analysis)
Philip Morris International Inc. (NYSE:PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company has raised dividends every year since the spin-off from Altria Group (NYSE:MO). Yield: 4.50% (analysis)
Wal-Mart Stores, Inc. (NYSE:WMT) operates retail stores in various formats worldwide. The company has raised dividends for 37 years in a row and has a ten year dividend growth rate of 17.80% per year. Yield: 2.80% (analysis)
PepsiCo, Inc. (NYSE:PEP) engages in the manufacture, marketing and sale of foods, snacks and carbonated and non-carbonated beverages worldwide. The company has raised dividends for 39 years in a row and has a ten year dividend growth rate of 13% per year. Yield: 3.20% (analysis)
Medtronic, Inc. (NYSE:MDT) manufactures and sells device-based medical therapies worldwide. The company has raised dividends for 34 years in a row and has a ten year dividend growth rate of 16.90% per year. Yield: 3% (analysis)