CVS Health (NYSE:CVS) had a disappointing 2016. It lost two big pharmacy benefit managers, Prime Therapeutics and Tricare, to Walgreens (NASDAQ:WBA) in the second half of the year. CVS' stock price cratered from nearly $100 to around $75 since Walgreens announced the first of those big wins.

Nonetheless, management offered another hefty raise to shareholders, increasing its quarterly dividend to $0.50 per share, an 18% increase. CVS has aggressively increased its dividend since 2010, when its annual payout was just $0.35 per share. In that time, CVS' dividend yield has gone from a paltry 1.1% to a much more meaningful 2.5%.

Still, a 2.5% yield is nothing to get too excited about. The real value of CVS' dividend is the potential for it to grow.

Female CVS Pharmacy front store employee with female customer.

Image source: CVS.

Management is committed to increasing the dividend every year

CVS has a growing track record of annual dividend increases. With its latest increase in December, that makes 14 years straight of dividend increases. CFO Dave Denton has no intention of breaking that streak. "We will continue to increase our dividend on an annual basis," he told investors during the company's third-quarter earnings call last year.

At the company's analyst day, Denton said he's targeting a payout ratio of 35% by 2018. That might scare investors that see the company's trailing-12-month payout ratio is already 37%. But consider earnings were artificially lowered due to extinguishing debt early and extra expenses for noncancelable lease obligations it had to pay as it closed some stores to streamline last year.

CVS guided for earnings per share of $5.77 to $5.93 in 2017. The $2 annual dividend represents about 34% of the $5.85 midpoint of that guidance. So, there's still some wiggle room to increase the payout ratio next year while still staying in line with Denton's guidance. What's more, there's no need for CVS to maintain such a strict cap on its payout ratio going forward, as it can't realistically grow its business fast enough to justify retaining nearly two-thirds of its earnings.

Dividends come from earnings. Will they grow?

While the near-term impact of Walgreens' PBM wins will depress earnings in 2017, CVS' own PBM provides a significant moat for it to continue increasing earnings into the future. Growing demand for healthcare from aging baby boomers will help increase both revenue and margins. CVS' scale allows it to reduce marginal costs of each claim processed and negotiate the lowest prices from suppliers.

Additionally, CVS' board has authorized a hefty buyback program. The company already bought back $3.6 billion worth of shares in the first quarter, reducing its share count by about 3.2%. Overall, CVS plans to buy back a total of $5 billion worth of shares in 2017, and it still has $14.6 billion left in its authorization.

Reducing the share count means earnings and the dividend can climb without having to increase the total net income or dividend paid.

It's also worth considering that CVS has significant depreciation expenses every year from its real estate (storefronts). As a result, its cash flow significantly exceeds its net income, so it can actually afford to spend a little extra on dividends and buybacks as a percentage of earnings.

So, how much can the dividend grow?

Investors shouldn't expect the 25% average dividend growth rate they've experienced over the last five years to continue. CVS' dividend is a much more significant portion of earnings today, bumping up against that synthetic 35% payout ratio cap. Importantly, CVS can only grow net income so much through its own internal investments. That means either slower net income growth going forward or CVS will need cash for acquisitions.

Realistically, CVS should be able to manage long-term organic net income growth of around 5% to 7% per year thanks to aging baby boomers' need for prescriptions combined with inflation and margin improvements. With a return on equity of around 16%, CVS theoretically only needs to retain about 38% of earnings to achieve that growth through internal investments. That would leave as much as 62% for dividends and buybacks.

Combine that net income growth with an aggressive buyback program, which has CVS buying back a whopping 13% to 18% of the company over the next few years, and the potential for dividend growth looks pretty good. Even if CVS kept its payout ratio cap at 35%, the organic earnings growth and the buyback suggest it could keep raising its dividend at a rate of 9% to 12.5% for the next three or four years.

Note that Wall Street analysts expect 7.9% earnings growth over the next five years, but that includes a flat 2017, which is already accounted for with the payout ratio of 34% based on management's guidance. Removing 2017 from the equation gives an annual EPS growth rate of 10% from 2017 to 2021 based on analysts' estimates -- in line with my expectations above.

If CVS decides to focus more on its dividend than share repurchases in the future, it could see the payout ratio climb higher, closer to the theoretical limit of about 60% based on a 6% internal growth rate. That gives CVS a lot of room to keep raising its dividend at a very good rate for a long time.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.