Wednesday, July 6, 2011

The Most Important Thing To Consider When Selecting A Dividend Stock

In selecting a dividend growth stock, investors look at many metrics and try to determine what the future holds for the company. Among those considered are free cash flow, debt levels, current yield, dividend growth rate and fair value. Not to diminish any of these, because they are all very important, but they are not the most important thing that we need to look for.

Free cash flow helps define the viability of the business to generate sufficient cash to meet the operating expenses and replacement capital. A high debt level can be a drain on free cash flow, sometimes to the point the company can no longer afford to pay a dividend.

Current yield defines the money we will earn today. If it is too low we may not be able to cover our living expenses. Inflation is inevitable, especially when the money supply is expanded. A robust dividend growth rate in excess of inflation will ensure we never lose purchasing power.

When selecting a dividend growth stock there is really only one factor that is important – sustainability. As dividend growth investors we are looking for stocks that will continue to raise their dividends into the future.

Below are three things I consider when assessing the sustainability of a dividend growth stock:

Years Of Consecutive Dividend Increases

Inertia is powerful force. Once a company has established a track record of growing its dividend over the decades and developed a shareholder base that expects higher dividends each year, it becomes increasing difficult for management to cut or fail to raise their dividend. No CEO of this type of company wants a dividend cut to occur on his or her watch. There are precious few Dividend Aristocrats remaining and those left enjoy their elite status.

Strong Financial Condition

Dividends are paid with cash, not earnings. Ultimately, investors must focus on the ability of a company to generate cash. In addition to the metrics mentioned above, I also look for:
Declining Shares Outstanding: I am leery of a company that consistently grows its shares outstanding in the absence of major acquisitions.

Growing Equity: If shares outstanding aren’t increasing, and equity is rising then the business is more likely to generate sufficient earnings to cover dividends and share repurchases.

Business Outlook

With the abundance of information available on the internet, the ability to judge past performance is quite simple. One of the most difficult challenges an investor faces is to determine are the future prospects of a company. Certain questions have to be answered. Is the company in a declining industry? Will it be able to reinvent itself in a way that will allow it to sustain growth? What external force could radically change the prospects of the company? These same questions are being asked by the company’s board, and they are equally hard for management to answer even with full access to insider information.

Dividend Stocks With A Sustainable Dividend

Below are several stocks that have increased their dividends for 25 or more years, with a free cash flow payout less than 60%, debt to total capital less than 45%, dividend growth greater than 2% and dividend yield greater than 2.5%:

Medtronic Inc. (MDT) | 34 Years | Yield: 2.5%
Growth Rate: 7.8% | Debt: 41.2% | FCF: 28.7%
Medtronic a global medical device manufacturer has leadership positions in the pacemaker, defibrillator, orthopedic, diabetes management, and other medical markets.

AFLAC Incorporated (AFL) | 29 Years | Yield: 2.6%
Growth Rate: 15.0% | Debt: 22.8% | FCF: 7.2%
Aflac Incorporated provides supplemental health and life insurance in the U.S. and Japan. Products are marketed at work sites and help fill gaps in primary insurance coverage. Approximately 80% of earnings comes from Japan and 20% from the U.S.

Automatic Data Processing Inc. (ADP) | 35 Years | Yield: 2.7%
Growth Rate: 5.2% | Debt: 0.6% | FCF: 45.7%
Automatic Data Processing Inc. is one of the world's largest independent computing services companies, providing a broad range of data processing services.

Wal-Mart Stores, Inc. (WMT)| 37 Years | Yield: 2.7%
Growth Rate: 13.3% | Debt: 41.0% | FCF: 36.6%
Wal-Mart Stores, Inc. is the largest retailer in North America and operates a chain of discount department stores, wholesale clubs, and combination discount stores and supermarkets.

Bemis Company, Inc. (BMS)| 28 Years | Yield: 2.8%
Growth Rate: 3.2% | Debt: 39.9% | FCF: 40.0%
Bemis Company Inc. is a leading maker of a broad range of flexible packaging and pressure-sensitive materials.

Procter & Gamble (PG) | 54 Years | Yield: 3.1%
Growth Rate: 9.4% | Debt: 31.8% | FCF: 57.2%
The Procter & Gamble Company is a leading consumer products company that markets household and personal care products in more than 180 countries.

Johnson & Johnson (JNJ) | 49 Years | Yield: 3.2%
Growth Rate: 2.4% | Debt: 22.9% | FCF: 45.1%
Johnson & Johnson is a leader in the pharmaceutical, medical device and consumer products industries.

Genuine Parts Company (GPC)| 55 Years | Yield: 3.3%
Growth Rate: 4.8% | Debt: 14.8% | FCF: 56.2%
Genuine Parts Co is a leading wholesale distributor of automotive replacement parts, industrial parts and supplies, and office products.

Diebold, Inc. (DBD) | 58 Years | Yield: 3.6%
Growth Rate: 3.7% | Debt: 39.5% | FCF: 38.8%
Diebold, Inc. provides ATMs and other self-service transaction systems and security products to the financial, commercial, government and retail markets.

WGL Holdings Inc. (WGL) | 35 Years | Yield: 4.0%
Growth Rate: 2.1% | Debt: 35.7% | FCF: 54.3%
WGL Holdings Inc. provides natural gas service in the Washington, DC, metropolitan area and surrounding regions, including Maryland and Virginia.

The ability of a stock to sustain its dividend separates dividend growth stocks from stocks that simply pay a dividend. The latter is quite common, while the former helps define the Best Dividend Stocks in the World.

Full Disclosure: Long GPC, JNJ, PG, WMT, ADP, MDT. See a list of all my income holdings here.

Related Articles
- 8 Dividend Stocks Covering Their Dividend
- Why Dividend Stocks Are Evil
- Don't Touch These 5 Dividend Stocks!
- 3 Dividend Stocks That I Will NEVER Lose Money On
- List of 195 Dividend Stocks Every Income Investor Should Know About
(Photo Credit)

Tags: [WGL] [DBD] [GPC] [JNJ] [PG] [BMS] [WMT] [ADP] [AFL] [MDT]