The best dividend stocks are great businesses, but not all great businesses are great dividend stocks. To be considered among the latter, companies need to jump a number of dividend-related hurdles -- five to be exact.
1. A verbal commitment
You care about dividends, so it makes sense the company should, too. Take this quote from Realty Income's (O 0.24%) CEO John Case in his 2014 letter to shareholders: "Our mission, as always, is to manage our real estate assets so that they continue to generate the lease revenue to support growing monthly dividend payments."
Or this quote from Aflac's (AFL -0.65%) CEO Daniel Amos in his 2014 letter to shareholders: "As we have said for many years, when it comes to deploying capital, we still believe that growing the cash dividend and repurchasing our shares are the most attractive means." Even if you have never heard of Realty Income or Aflac, you can understand that paying dividends is important to these companies.
2. Proven dividend track record
But talk can be cheap. You are also going to want proof that the company is following through on its verbal commitment. Aflac and Realty Income have increased their dividend every year for at least the last two decades.
There is no assurance this will continue, but a long track record adds to a company that claims to have a commitment to their dividend and, when given the choice, I'll bet on companies that have a proven track record.
3. Model for consistency
Long dividend track records are often made possible because certain companies can generate predictable income -- and that is exactly what you want.
Realty Income is the perfect example. The company owns a portfolio of 4,473 predominately single-tenant retail properties leased to stable businesses like Walgreens. Most important, the remaining term on these leases averages 10 years. That has helped to keep the company's historical occupancy above 96% and allow for predictable dividend payments.
The same is true for Aflac. And it starts with the consistent demand for the company's branded supplemental health and life insurance products. From 2005 to the end of 2014, policies in force, or outstanding, steadily increased from 36 million to 47.4 million.
The customers behind these policies pay premiums, and while Aflac is waiting to pay the money back in claims, the company gets to invest it. Even better, when money eventually goes back to customers, Aflac is normally paying back less than what they collected in premiums. It creates a double whammy; Aflac earns money through their investments, and by writing insurance. The combination of a profitable business and steady demand for their products is a big reason why Aflac has been so consistent.
4. Higher than average yield
Beyond the nuts and bolts of the business, you're also going to want some bang for your buck. Dividend yield is a company's annual dividend per share divided by stock price. Currently, Realty Income has a dividend yield of 4.6% and Aflac is yielding 2.6%. Both of which are above the 2.3% yield on 10-year Treasury bonds, and the S&P 500's 2% yield.
The higher the yield the bigger your dividend check. But it can be much more than that if you play your cards right. Reinvest dividends to buy additional shares of stock and you unleash the power of compounding.
5. Growth of income
The real money is made through dividends plus stock appreciation -- and dividend growth is an important factor in that formula. This is because a company's stock price follows the growth of income. It may not happen in lock step, but companies that grow dividends eventually see their stock price follow.
Over the last five years, Realty Income has tripled the size of its real estate portfolio from $4 billion to $12 billion. And this isn't just growth for the sake of growth. Realty Income has a history of growing responsibility; which means asset growth leads to earnings growth. This has allowed the company to increase its dividend by an annual rate of 6% since 3Q 2010.
Aflac has also had strong dividend growth. The company has been expanding product lines and growing policies in force, but the secret for Aflac is that its business requires limited reinvestment to generate profits. This allows the company to buy back a ton of shares. In fact, Aflac has bought back over $3 billion worth of shares, or 9% of outstanding shares over the last five years. This has helped to juice Aflac's dividend growth to 8% annually since 3Q 2010.
The most important thing
If I can leave you with a parting thought: start with a great business. Long track records and high yields are icing on the cake. It not as delicious without it, but it all begins with a solid foundation. Start with a wonderful business, decide if it has the five additional qualities, and you will be spotting top-notch dividend stocks like Realty Income and Aflac in no time.
