Dividend stocks are an essential ingredient to a well-balanced portfolio. Even so, it's important to bear in mind that not all dividend stocks are created equal.
When picking over potential dividend candidates, you should look for companies with clean balance sheets, healthy free cash flows, and a history of increasing payouts.
Johnson & Johnson (JNJ 0.29%) is in many ways an ideal dividend stock for investors with a long-term outlook. The company has a long-standing history of increasing total dividend payouts to shareholders, and its balance sheet stands out as one of the best in the healthcare sector. With this in mind, let's dig deeper into why J&J is worth consideration as a dividend play.
J&J's use of free cash flow is key
Although many investors skip over cash flow statements and go right to the income statement, cash flows are critical to understanding the ability of a company to reward shareholders and expand operations to create deep value. In short, cash flow statements give investors an unfettered look at the health of a company.
By poring over J&J's cash flow statements, we can see that the company has made it a priority to boost dividend payouts to shareholders:
But that's not all. J&J has also frequently used its free cash to repurchase shares, which leads to less volatility during turbulent markets and helps to drive prices higher over time.
To illustrate my point, let's look at how J&J's share price has performed in relation to its monthly volatility over the past five years, and compare it with its healthcare peers AstraZeneca (AZN 1.03%) and GlaxoSmithKline (GSK 1.60%).
Despite some wild market swings during the past five years, J&J's stock price has steadily ticked higher and has experienced considerably less volatility compared with two of its top peers.
What's key to understand is that AstraZeneca and Glaxo have slacked off on share repurchases in the wake of the so-called patent cliff. So even though AstraZeneca and Glaxo sport dividends topping 5% at current levels -- nearly doubling J&J's 2.68% yield, these high-flying yields come with the headache of increased volatility. To top it off, J&J has handily outperformed these two high-yielding healthcare stocks over the past decade:
Through the first half of 2014, J&J has now boosted its dividend payout by nearly $300 million compared with a year ago and bought back an impressive $1.9 billion in shares. With earnings expected to increase by 7.1% next year, I look for this long-term trend to continue going forward.
Pharmaceutical sales are the driving force behind J&J's growth
In a period where many top healthcare companies are facing falling revenues because of the double whammy of the patent cliff and the newly implemented medical-device tax, J&J has easily set itself apart from the pack with the development of two new blockbuster drugs.
Specifically, J&J has seen its advanced prostate cancer treatment Zytiga and its newly launched hepatitis C drug Olysio grow into major revenue drivers lately.
Turning to the details, Zytiga sales have already hit $1.074 billion in the first six months of 2014, up an astounding 45% compared with a year ago. By the same token, Olsyio has racked up $1.185 billion in sales so far this year. In addition, J&J sports a handful of other drugs seeing double-digit sales growth year over year.
J&J's pharmaceutical segment should thus continue to generate positive cash flows for at least the next few years.
Foolish wrap-up
There are a number of important factors to consider when picking a dividend stock for your portfolio, and surprisingly enough, yield might be one of the least important.
For instance, investors might be initially attracted to a noteworthy yield -- such as those AstraZeneca and Glaxo are offering -- but a closer look under the hood reveals some worrisome trends from a growth and cash flow perspective. Compared with its peers, J&J offers only a middle-of-the-pack yield but much stronger prospects in terms of generating free cash flow moving forward.
On a final note, J&J investors who employed a dividend reinvestment plan would be looking at a princely 175% gain over the past decade. An investment in the S&P 500, by contrast, would have yielded roughly 85% over the same time period -- showing the power of reinvesting dividends in a top-flight name like J&J. As such, I think this is a stock that all dividend investors should carefully consider for their portfolios.
