These Stocks Have What You Want

If you're looking to get income from your investments, you'd probably agree that more is better -- and you can find dividend stocks that will give you the income you want. So how can you pick stocks that not only pay you healthy dividends now but will continue to increase their payouts in the future?

What's behind a dividend stock
To answer that question, I decided to take a closer look at companies that have put together a long track record of dividend increases. By looking for common themes among the stocks that consistently increase their payouts, we'll hopefully find clues of what to look for among younger companies that don't yet have such long histories of rising dividends.

Here are some of the traits that I found frequently among top dividend stocks.

1. Modest (but positive) growth rates.
Choosing whether to pay dividends and how big they should be is, at heart, a capital allocation decision. Shareholder dividend payments have to compete with other potential uses for the cash a business generates. If a fast-growing company needs most of its cash flow to support new business initiatives, there won't be anything left over for shareholders.

So when you look at the most solid dividend payers, you'll notice that they're not the fastest growers out there. Coca-Cola (NYSE: KO  ) , for instance, has seen five-year revenue and profit growth both clock in around 7% on an annualized basis. That's not shabby, but nowhere near what many high-growth stocks kick out. Abbott Labs (NYSE: ABT  ) has boasted revenue growth of 9% annually since 2005, and earnings rising by 12% annually.

Obviously, you can't grow dividends without some growth in earnings. But steady earnings over time give a better indicator of dividend growth than a flash-in-the-pan performance that is typically unsustainable and often leads to future consolidation and restructuring.

2. Manageable debt levels.
Similarly, a company with the wherewithal to increase dividends regularly can't afford to waste a ton of its cash making interest payments on large amounts of debt. So you'll typically find that dividend stocks have relatively modest debt levels.

That said, companies can have some debt and still pay dividends. Wal-Mart (NYSE: WMT  ) , for instance, listed almost $37 billion in long-term debt as of the end of January. But with more than $70 billion in shareholder equity, no one would say that Wal-Mart's debt is dangerously high. Similarly, despite bringing in more than $23 billion in revenue during 2009, 3M (NYSE: MMM  ) has long-term debt of just $5.6 billion -- and $3 billion in cash to offset it.

3. Healthy free cash flow.
It's not enough for dividend-paying companies to have good earnings. They also need to generate the actual cash that will go to shareholders. So you'll want to see companies whose free cash flow compares favorably with their reported earnings.

For instance, Altria Group (NYSE: MO  ) reported net income of $3.2 billion in 2009, and its free cash flow was almost identical to that figure, coming in at $3.17 billion. Even with an ultrahigh yield of 6.7%, Altria's payout ratio is only 86%, which is in line with the company's stated policy to return around 80% of its income to shareholders in dividend payments. Kimberly-Clark (NYSE: KMB  ) is arguably an even better example, as its 2009 free cash flow of $2.63 billion well exceeded net income of $1.88 billion.

4. Diverse product lines.
Over time, individual products go in and out of style. The best companies find ways to innovate and develop new products that diversify their businesses.

Even Coca-Cola, which you might think would be the ultimate one-product company, has diversified beyond its signature soda pop to encompass the entire beverage industry, from energy drinks and mineral water to juice and mixers. Colgate-Palmolive (NYSE: CL  ) sells much more than toothpaste and dishwashing liquid; you'll also find shaving products, laundry detergents, and even pet nutrition products among its offerings.

Of course, you don't want a company that's so diversified that it loses its focus. But a healthy mix in a company's product offerings is a good sign of long-term success.

Go for the gold
Knowing what successful, mature companies look like can help you identify those same traits in younger, less-followed ones. If you run across traits like these in your research, take note. You may be an early discoverer of a stock that will pay ever-increasing dividends for years to come.

Don't settle for second-best. Fool contributor Jordan DiPietro wants to show you the best dividend stock -- period.

Fool contributor Dan Caplinger tries to find the dividend in all his investments. He owns shares of Altria Group. Coca-Cola, 3M, and Wal-Mart Stores are Motley Fool Inside Value picks. Kimberly-Clark and Coca-Cola are Motley Fool Income Investor recommendations. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy pays you back every day.


Read/Post Comments (3) | Recommend This Article (10)

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  • Report this Comment On April 21, 2010, at 10:29 AM, madmilker wrote:

    "That said, companies can have some debt and still pay dividends."

    duh! what you didn't say...

    Each year Wal*Mart sells Bonds...

    March of 2009 and July 2009....and this past month announce another sell....and don't come back with that ....it ain't no big deal...cause if it wasn't...all that cash that they are suppose to generate...just why are they $37 billion in debt in the first place.

  • Report this Comment On April 21, 2010, at 11:22 AM, Truclarson wrote:

    3M has and continues to be one of my best investments for many years! When I try to get clever, I do less than my 3M holdings.

  • Report this Comment On April 21, 2010, at 11:24 AM, Truclarson wrote:

    Test.

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