Dividend stocks are a reliable way to build wealth in the long run, but if the companies you invest in also mint money -- in the form of free cash flow -- your returns could multiply. Dividend-paying companies that consistently convert a good portion of sales and profits into cash flows are better positioned to offer you stable, growing dividends than those with lighter war chests.
Need evidence? Just pick up some of the top dividend-paying stocks and look up their free cash flow trends and total returns. You'll generally find a positive correlation between the amount of free cash a company generates and the dividends it pays. However, I wouldn't recommend looking at just the FCF trend -- as cash flows can fluctuate -- to find which companies are minting money. I prefer the FCF margin.
FCF margin is simply the percentage of revenues that are converted into free cash flows. Dividend-paying stocks with double-digit FCF margins are money-making machines. Five great examples are Mastercard (MA +0.57%), Visa (V +0.00%), Johnson & Johnson (JNJ +0.84%), Procter & Gamble (PG +0.19%), and 3M (MMM 0.16%). Let's drill a little deeper into each.
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The more you swipe your cards, the more they mint
The two payments processing giants operate in a near duopoly, and given their strikingly similar businesses, it isn't surprising that both the companies enjoy hefty margins and are making good a lot of money. So much so that it's hard to find dividend stocks today with better FCF margins than Mastercard and Visa.
V Free Cash Flow (% of Annual Revenues) data by YCharts
You have no doubt heard of the "network effect," -- which applies to products and systems that become more valuable to the users the more people that use them? That's exactly what makes the business models of Mastercard and Visa so profitable. Millions of merchants, banks, and customers are connected to each other. When more merchants accept their credit and debit cards, more banks issue them, and more customers use them, thereby adding value to everyone involved. Mastercard and Visa primarily make money in two ways: they earn a percentage of the total global transaction volumes on all their cards, and also get a small fee per transaction. Today, both companies are generating billions of dollars in revenues.
However, it's only in recent years that Mastercard and Visa have started doling out higher dividends: Mastercard's dividend has doubled since 2014 while Visa's has tripled since 2012 (adjusting for its 4-for-1 stock split in 2015). Given their low payouts, strong cash positions, and the massive growth opportunities that the global shift from cash to digital payments offers, I see huge potential for their dividends to increase in the coming years.
This household name pays great dividends too
Procter & Gamble's inclusion in this list shouldn't be surprising. After all, a company that has made inroads into nearly every household with its incredible range of consumer goods must be minting money for sure. Tide, Pampers, Gillette, Oral-B, Crest, Charmin, Pantene, Bounty -- the list of P&G's popular brands is bigger than you probably know. And when it comes to dividends, it's hard to beat P&G's record: It is one of only six stocks that have raised their dividends annually for 60 straight years or more. Thank P&G's solid global footprint and the inelastic demand for its goods for its strong margins, cash flows, and dividends.
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P&G's focus right now is on streamlining operations and cutting costs. The company is aggressively divesting itself of low-margin businesses like Coty and Duracell in line with its plans to knock out $10 billion in costs in the next five years. Lower costs should further boost the company's margins and cash flows, which should mean bigger dividends for shareholders in coming years.
Here's your dividend Post-it
You may not know much about 3M, but chances are you've been using its products regularly -- unless you've never tried Post-it notes or Scotch Tapes, that is. Though 3M manufactures a lot more than just those low-key products – its portfolio includes more than 60,000 products and 100,000 patents.
3M is now generating revenues north of $30 billion, and has converted 80% or more of its net income into FCF in each of the past five years. If that isn't incredible enough -- being FCF positive itself is a sign of operational efficiency -- 3M has rewarded shareholders with annual dividend increases for 59 consecutive years now. There's little reason to believe it will break this streak anytime soon.
Management is, in fact, confident of making money going forward. It's targeting annual EPS growth in the 8% to 11% range through 2020. If 3M can even convert half its profits into FCF, investors can expect decent dividend growth, considering that 3M has paid out at least 40% of FCF in dividends in the past five years. In short, 3M will likely continue to pay rich dividends for years to come.
Blue chip, healthcare, and big dividends? Yes, you can have it all
From a consumer goods company to a healthcare titan, Johnson & Johnson's journey has been nothing short of stunning. Today, the company is a market leader across all its core business lines thanks to a combination of innovative leadership plus disciplined research and development spending. Foraying into healthcare proved a game-changer for Johnson & Johnson, as medical devices and drugs enjoy inelastic demand, which also explains why the company's sales and cash flows have trended higher over the years.
No wait -- that's an understatement: J&J has generated nearly as much or more in free cash flow as net income in each of the past five years, and its FCF has been well above $12 billion in each of those years. Yes, that's the kind of money this consumer-pharma titan is minting nowadays. J&J's dividend streak is even more impressive, with 55 consecutive years of payout increases.
Image source: Johnson & Johnson
While its consumer health products and medical devices segments are the slow-and-steady kind, J&J's pharmaceuticals division is the real margin generator. But when you factor in the kind of things the company is doing to advance its slow-moving businesses, there's every chance Johnson & Johnson's margins and cash flows could grow even more rapidly in the future, which could convert into fatter dividend paychecks for income investors.
