You've probably heard the story of how Warren Buffett picked up
shares of
Coca Cola
(
KO
) in the late 1980s through Berkshire Hathaway at a split-adjusted
price of just $5.48 per share.
While the stock has soared since then, what often gets overlooked
is that Coke has increased its dividend every year since then at a
compound annual rate of 11%. This means that Berkshire now collects
an annual dividend of $2.04 per share for a remarkable 37% yield on
cost!
Dividend stocks can be an excellent way to build long-term wealth.
But before you rush out and buy your next high-yielder, there are 4
things you need to consider first:
1) Know the Company's Payout Ratio
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. Companies
are not required to make dividend payments like they are debt
payments. If times get tough and money gets tight, checks to the
bank and to bondholders will get sent out before your dividend
check.
So what is the payout ratio, exactly?
It is simply the percentage of net income a company pays out to
shareholders in dividends:
Dividends / Net Income
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.
A company with a relatively low ratio of dividends to free cash
flow
may
just have some big dividend hikes on the horizon. 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 24% per year will essentially double it every 3 years.
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You may be tempted to look for income stocks that paid high
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2) Know the Company's Sustainable Growth Rate
There is tradeoff between high dividends and long-term earnings
growth. Obviously the more cash a company pays out to its
shareholders, the less it has to fund growth without either issuing
more debt or more equity.
It's not uncommon for businesses to distribute more and more of
their earnings to shareholders through higher dividends as they
mature. Bigger companies have less growth opportunities and compete
in crowded markets, so they plow back less of their earnings into
the company and more into your wallet.
But if a company is going to increase its dividend over time, it
needs to grow earnings and cash flow to do so. This is why it's
important to know a company's
sustainable growth rate
.
The sustainable growth rate is calculated as:
(1 - Payout Ratio) x Return on Equity
For example, say a company pays out 30% of its earnings in
dividends and its ROE is 15%. Its sustainable growth rate would be
10.5% (.70 x .15). Clearly the lower the payout ratio and higher
the ROE, the higher the sustainable growth rate. That means higher
future cash flow growth and, likely, higher future dividend growth.
3) Know the Company's Dividend Policy
There are a few different types of dividend policies, and it's
important to know which one a company follows. The most common
policy here in the United States is for a company to pay out a
quarterly dividend based around a long-term target payout ratio.
But some companies, particularly international firms, pay an annual
dividend based on a set percentage of earnings (say, 30% of net
income). This can make for some very volatile dividend payments.
But this goes beyond whether or not you get a dividend every three
months or once a year. It's important to know
who
is setting the dividend policy, and why.
Typically a company's board of directors will set the dividend
policy. That's why strong corporate governance is essential. One
indicator of strong corporate governance is a board comprised of a
majority of independent members.
If the board is made up mostly of company management, however, then
don't expect them to have your best interests in mind when setting
their dividend policy. Management usually prefers to hoard cash
rather than return it to shareholders. And instead of investing it
in value-added projects, they are prone to making dumb acquisitions
or buying company jets or excessively padding a 'rainy day' fund.
If you want a company that makes generous dividend hikes year after
year, make sure it has strong corporate governance.
4) Consider Earnings Momentum
Studies have shown that earnings estimate revisions are the most
powerful force influencing stock prices. And let's face it, a
dividend check will provide little consolation if the stock price
is about to fall off a cliff.
Moreover, it's been shown that companies with positive estimate
revisions tend to produce positive earnings surprises and see
additional
positive estimate revisions, while companies with negative estimate
revisions tend to deliver negative earnings surprises and see
additional negative revisions.
This cycle, or
earnings momentum
, can go on for quite some time. In other words, an object in
motion tends to stay in motion.
This can also provide insight into whether a dividend hike is on
the horizon. If a company is continually missing earnings
expectations, don't expect to see big dividend increases any time
soon.
I like to see companies with at least stable earnings momentum. And
the best indicator for this is the Zacks Rank. Look for companies
with a Zacks #3 Rank (Hold) or better.
Where to Find Good Dividend Stocks and More
There's an easy way to apply these rules for the benefit of your
portfolio. In March, we released our first portfolio that
concentrates on dividend stocks with great upside potential. So if
you need some help finding them, then please come and discover the
current selections of our new
Income Plus Investor.
I'm directing the search for rare stocks with growth potential that
are not only paying high dividends now but are likely to do so for
many quarters to come. Then we add other low-risk vehicles like
MLPs, REITs, Covered Calls and special ETFs to fly past fixed
income investments that actually lose out to inflation.
The goal is a steady, market-topping flow of returns through all
conditions, and especially during volatile periods like we're
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Good investing,
Todd
Todd Bunton is the Growth & Income Stock Strategist for
Zacks Investment Research and Editor of the
Income Plus
Investor
service.
COCA COLA CO (KO): Free Stock Analysis Report
COCA COLA CO (KO): Free Stock Analysis Report
COCA COLA CO (KO): Free Stock Analysis Report
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