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4 Rules of Dividend Investing

Todd Bunton

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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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.

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Good investing,

Todd Bunton is the Growth & Income Stock Strategist for Zacks Investment Research and Editor of the Income Plus Investor service.

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