When the economic climate gets rough, many companies are forced to reduce or even outright eliminate their dividends. They have no choice: Cash flow falls, and any efforts to sustain a dividend at current levels bleeds cash from the balance sheet.
But there's a straightforward way to assess not just the safety of a dividend, but its growth prospects as well. [In fact, this is a key part of what we call the Dividend Trifecta strategy.] The key is to find companies with solid track records of sales, cash flow and net profit growth. Indeed, across the S&P 500, S&P 600 (a small-cap index) and S&P 400 (a mid-cap index), it's possible to find dozens of companies that have been able to generate double-digit average annual gains in those metrics during the past five years.
Yet among these steady growers, it's also possible to find a more limited group that also pays a dividend. Once you're focused on this group, there's a simple way to calculate how much a dividend might grow. In a nutshell, the lower the payout ratio (the amount of funds spent on dividends, divided by net income), the higher the potential dividend growth rate.
Let's use Coca-Cola (NYSE: KO) as an example. Coca-Cola has boosted sales, cash flow and net profits at a roughly 12% annual pace during the past five years. Yet Coca-Cola's dividend has risen at a more tepid 8% pace in that time. That's because Coca-Cola already pays out so much of its income into dividends -- 51% in the past 12 months -- that it's hard-pressed to do much more for the dividend without creating an uncomfortably high payout ratio. Coca-Cola's per-share earnings will likely rise just 4% in 2012 to $2, according to analysts. And they're likely to grow less than 10% in 2013 as well, meaning future dividend growth will likely be quite muted.
For a number of other companies, near-term profit growth may also slow if we're faced with a weak economy in 2013. But they can still hike their dividends at a vigorous pace -- if their current payout ratio is quite low.
Take Apple (Nasdaq: AAPL) as an example. The consumer electronics giant offers a so-so dividend yield of 2%. But it can do so much better in the future simply because its current dividend payout ratio is a quite reasonable 24%. If Apple took that payout ratio to 50%, then the dividend yield would rise to 4%. Frankly, with more than $100 billion in net cash parked on its books, Apple could easily afford to return all of its net income to shareholders in the form of a dividend. That would work out to be a 9% dividend yield.
Solid Growth and Reasonable Payout Ratios
Every company on this table is well positioned to deliver steady and robust dividend gains. Not only have they proven their ability to steadily boost sales and profits in recent years, but analysts predict that each of these companies will boost sales and profits in the next two years as well.
Glancing at the table above, the dividend yields may seem a bit subpar. But it's crucial to remember the power of compounding. If you buy these stocks and hold them for a considerable period of time, then dividend yields down the road (on your original cost basis) are likely to become much more robust. The fact that they have low payout ratios means they can afford to keep pushing the dividend higher, even in years when sales and profit growth fail to materialize. Said another way, these companies are quite unlikely to be forced to cut their dividends in tough times, thanks to those already-low payout ratios.
Risks to Consider: Tax rates on dividends may steadily rise in coming years as Washington seeks new ways to raise revenue. That's why dividend-paying stocks are often best owned in tax-shielded retirement accounts.
Action to Take --> Capturing rising dividend streams can be a safe approach in uncertain markets. It's hard to know what to expect from the market in any given year (indeed the S&P 500 is below where it stood in 2000). But solid and rising payouts can ensure you'll still reap gains.