Amid record profitability, companies are paying out more and more dividends to shareholders. In 2014, 423 companies in the S&P 500, or 84%, paid dividends. That marks the highest percentage since 1997.
Additionally, a whopping 375 companies increased their dividends last year. And 267 firms have already increased so far in 2015.
Paying Dividends Is a Major Commitment
When a company decides to increase its dividend rather than just buy back stock or sit on the cash, it’s a signal to investors that management is confident in the outlook of the business.
The reason for this is that dividends represent more of a long-term commitment because companies can usually decide to simply stop buying back stock at any time without any major repercussions. On the other hand, if a company decides to stop paying its dividend, investors will flee the stock.
New York University finance professor Aswath Damodaran put it this way:
“Dividends are like getting married; stock buybacks are like hooking up.”
Valuing Dividend Growth Stocks
For investors with a long-term horizon, it’s important to not only look at a stock’s current dividend yield but also to look at its payout ratio. A payout ratio is simply the percentage of net income a company pays out in dividends.
Even better – go to the company’s statement of cash flows and look at the percentage of dividends paid to its free cash flow, which is just cash from operations less capital expenditures.
Knowing a company’s dividend payout ratio is vital. Typically the higher the payout ratio, the less room a company has to raise its dividend in the future. And if a company becomes distressed, a high payout ratio can signal a significant cut is on the way.
A company with a relatively low ratio of dividends to free cash flow, on the other hand, may just have some big dividend hikes on the horizon. This is typical of a younger, fast-growing company, assuming it even pays a dividend at all. As the company grows and matures, however, it will have less growth opportunities and will usually plow back less cash into the company and more into your wallet.
That means a decent dividend yield today could become a huge yield in the future.
For instance, a company that raises its dividend an average of 12% per year will double its dividend every 6 years. And at 18%, it will double every 4 years.
Let’s consider an example.
Fictional XYZ Corp makes widgets. It trades for $50.00 per share and currently pays a dividend of $1.25 for a yield of 2.5%. It earned $3.75 per share this year, so its payout ratio is currently 33%. You decide to buy some shares today.
Let’s assume that over the next 10 years, XYZ sees its earnings grow steadily at 8% per year. At the end of 10 years, it will be earning $8.10 per share. Let’s assume that the company decided to steadily increase its payout ratio each year too, increasing its dividend at a 16% annual rate. By the end of year 10, the company is paying out 68% of its earnings in the form of dividends. This equates to a dividend of $5.51 per share, or a whopping 11.0% yield on your original cost! This ignores any capital gains you might have, too.
Clearly, a company’s dividend growth potential is very important for long-term investors.
But for a company to consistently raise its dividend at such a high rate over a long period of time, it needs to generate solid, steady free cash flow, have a solid balance sheet, and more than likely raise its payout ratio.
Stocks with Excellent Dividend Growth Potential
Listed below are five stocks with great potential for big dividend increases over the next several years. They each have strong cash flow, solid balance sheets, a history of healthy dividend increases and a relatively low payout ratio.
Accenture (ACN)
Current Dividend Yield: 2.1%
5-year Dividend Growth Rate: 20%
Trailing 12-month (TTM) Free Cash Flow Payout Ratio: 35%
Debt/Total Capital: 14%
Quest Diagnostics (DGX)
Current Dividend Yield: 2.3%
5-year Dividend Growth Rate: 31%
TTM Free Cash Flow Payout Ratio: 40%
Debt/Total Capital: 47%
Dr Pepper Snapple (DPS)
Current Dividend Yield: 2.3%
5-year Dividend Growth Rate: 18%
TTM Free Cash Flow Payout Ratio: 42%
Debt/Total Capital: 48%
Gentex (GNTX)
Current Dividend Yield: 2.2%
5-year Dividend Growth Rate: 9%
TTM Free Cash Flow Payout Ratio: 31%
Debt/Total Capital: 13%
Target (TGT)
Current Dividend Yield: 3.0%
5-year Dividend Growth Rate: 18%
TTM Free Cash Flow Payout Ratio: 32%
Debt/Total Capital: 49%
These five companies have all made strong commitments to shareholders through consistent dividend hikes. With solid balance sheets, strong free cash flow and low payout ratios, these companies are likely to continue boosting their dividends for years to come.
Todd Bunton, CFA is a Stock Strategist for Zacks Investment Research and Editor of the Income Plus Investor and Surprise Trader services.
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TARGET CORP (TGT): Free Stock Analysis Report
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QUEST DIAGNOSTC (DGX): Free Stock Analysis Report
ACCENTURE PLC (ACN): Free Stock Analysis Report
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