A Better Breed of Dividend Stock

Today's low interest rate environment has Foolish investors searching for income-producing investments. We feel your pain. Given these dire straits, investors have increasingly turned to dividend-paying stocks for the income they so desperately desire.

Ring that register
Those little checks you receive in the mail (or used to before that whole Internet, e-brokerage thing) actually do more than give you a warm, fuzzy feeling. Evidence proves stocks that pay dividends outperform non-dividend-paying stocks and the broader market over the long term. In a recent article, heralded finance professor Jeremy Siegel echoed as much, saying, "the evidence is overwhelming that dividend-paying stocks are still your best long-term investment. Through the years, diversified portfolios of stocks that pay dividends have not only beaten those that don't, but they have also handily outperformed the S&P 500." It doesn't get much more convincing than that.

A better breed
And while I hope it's abundantly clear we should love dividend stocks, I'll contend that an additional subset exists that provides even greater value than simple dividend payers -- companies that consistently grow their dividends. To support this, I'll employ some basic financial math and common sense (whichever you prefer). Bear with me ... good things to come.

Let's quickly consider two dividend stocks -- one that doesn't grow its dividend (we'll call it Company A) and one that does (named Company B). I'll use what's known as the Gordon Growth Model in finance theory to demonstrate my point. The Gordon Growth Model asserts a stock's value is equal to its dividend one period from now (D) divided by its discount rate (k), the rate of return used to reconcile future cash flows to the present, minus the dividend growth rate (G), or for the visual learners in the bunch, like this:

Stock Value = D / (k - G)

Let's make some quick assumptions in order to work our way through the model for both companies. Let's say each company pays the same $1 dividend one year from now (D = $1). For simplicity's sake, we'll also say the discount rate (k) equals 10% and the dividend growth rate equals 5% for Company B only (remember 0% dividend growth for Company A). Some quick arithmetic reveals the values for the respective companies:

Company A value = $1 / .10 = $10

Company B value = $1 / (.10-.05) = $20

While I'll never argue the model works with a high degree of precision, this should convey the general concept. This should also make intuitive sense as well. A company that can grow its payments to its investors should be worth more than one that doesn't. The owner of the stock will receive more money in the form of greater payouts with the growing stream of payments versus the non-growth dividends. 

Historical returns also support this line of thinking. Over the last five years, companies that grew their dividends trounced those of companies whose dividends contracted (pretty intuitive there as well). However, companies that grew their dividends more than 5% annually obliterated both companies growing their payouts at annual rates and the broader market. It seems growing dividends equate to growing profits for investors.

Are they really out there?
Given all this, I perused the market to see if any interesting dividend growth opportunities might exist today. I looked for companies that currently sell for less than the P/E for the S&P 500 (you should never overpay for stocks), pay a dividend greater than 3%, and averaged 5% annual dividend growth for the last 10 years. Out of all the companies my search produced, I found the following names most compelling:

Company

Dividend Yield

Avg. Dividend Growth Rate (Last 10 Years)

Price / LTM Diluted EPS Before Extra

Mattel 3.4% 69.8% 14.7
CenturyLink (NYSE: CTL  ) 7.2% 60.8% 13.5
Sun Life Financial (NYSE: SLF  ) 5.0% 42.0% 10.3
Intel (Nasdaq: INTC  ) 3.3% 28.8 % 10.1
Federated Investors 3.9% 22.1 % 14.9
Harte-Hanks (NYSE: HHS  ) 3.8% 16.1 % 10.7
ConocoPhillips (NYSE: COP  ) 3.6% 12.5 % 8.87
Meredith 3.2% 11.5 % 11.1
Raytheon (NYSE: RTN  ) 3.5% 6.7 % 10.8
UGI (NYSE: UGI  ) 3.3% 5.9 % 13.1

Source: Capital IQ, a Standard & Poor's company.

While many of the eye-popping growth rates seen above result from the companies' boosting their dividends from very low levels, typically coming out of a difficult economic period or as the result of a change in company policy, that doesn't explain the entire growth picture here. Even in such cases, these companies have all shown their ability to grow their dividends consistently over long stretches of time. And while you might not enjoy such breakneck growth rates going forward, investing in companies that consistently increase their payouts clearly benefits investors.

Foolish takeaways
As we learned above, dividend stocks as a whole beat the market over the long term, but stocks with growing dividends outperform normal dividend-paying stocks. In order to do so, you always need to dig deeper than a few key figures before you buy. Winning investors always combine a sound strategy with detailed knowledge of what they buy. While the stocks above will make for a great place to start your hunt, this process should only be beginning.

And if dividend stocks interest you, you should also read The Fool's special report, "13 High-Yielding Stocks to Buy Today," for additional ideas for great dividend stocks. It's free to read. Just click here to access your complimentary copy today!

Andrew Tonner holds no positions in any of the companies mentioned in this article. The Motley Fool owns shares of Raytheon. The Fool owns shares of and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of UGI, Federated Investors, and Intel. Motley Fool newsletter services have recommended creating a diagonal call position in Intel. 

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (71)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 24, 2011, at 9:01 AM, shortscope wrote:

    Where does one find or how does one determine the company's dividend discount rate?

  • Report this Comment On June 24, 2011, at 1:42 PM, ScottRichard wrote:

    Please Andrew, define your acronyms and terms, "Price / LTM Diluted EPS Before Extra".

    "LTM"? "Before Extra" extra what?

  • Report this Comment On June 24, 2011, at 1:43 PM, TMFTheDude wrote:

    People will typically adjust a generic equity risk premium slightly to find an appropriate discount rate. Equity risk premiums usually range between 10-12% most often.

  • Report this Comment On June 24, 2011, at 1:56 PM, TMFTheDude wrote:

    Hi Scott,

    Sorry if the phrasing sounded confusing. I tried to keep the formatting concise.

    LTM = Last Twelve Months

    Before extra = before extra items. Companies will often present an earnings calculation that differs from reported earnings by backing out one-time expenses, extraordinary expenses, etc. In theory, this should help increase comparability from company to company and across varying time horizons.

  • Report this Comment On June 25, 2011, at 9:52 AM, ChrisLynn1 wrote:

    Thanks for the article. I'm still VERY lost regarding the Discount Rate. I see your response that Equity risk premiums usually range between 10-12%. Is this something that I assign to the stock or can it be found somewhere? If it's something that I assign, do you have any guidance regarding how to determine an appropriate rate?

  • Report this Comment On June 28, 2011, at 12:59 PM, ScottRichard wrote:

    Andrew,

    Thanks for the clarification on LTM and Extra. I'm feeling kind of stupid. I guess I'm used to TTM- trailing twelve months instead.

    Thanks, Scott

  • Report this Comment On July 01, 2011, at 6:55 PM, whyaduck1128 wrote:

    I love "one-time expenses" and "extraordinary expenses". Sometimes they really are "one-time" or "extraordinary", but in my experience they are more of a refuge or excuse for "we spent like a sailor on shore leave, so to make everything look normal we're tossing some expenses into a separate category, otherwise you'd throw us out on our a**es".

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