The data is indisputable. Companies that grow their dividends on a consistent basis have outperformed non-payers by a significant margin over the long term. Going all the way back to 1972, stocks in the S&P 500 that initiated and grew their dividend produced an average annual return of 9.89%, according to a study by Ned Davis Research.

Non-payers, on the other hand, only delivered a 2.39% total annual return over that timeframe while companies that do pay a dividend but didn't provide regular dividend increases achieved an average total annual return of 7.37%. That outperformance by dividend growth stocks makes it clear that they're an excellent way for investors to build long-term wealth.

However, while buying companies that have a history of producing a growing dividend income stream is a good place to start, it's best to focus on those that have the greatest potential to increase their payouts on a regular basis in the future. That means focusing less on a company's current dividend yield, and more on its payout ratio and growth prospects. This guide will walk investors through those aspects and more to help them identify the best dividend growth stocks for the long haul.

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What are dividend growth stocks?

A dividend growth stock is a company that increases its dividend on a semi-regular basis. Some companies raise their payouts very regularly such as at the same time each year or even quarterly. While there isn't an official definition of what qualifies a company as a dividend growth stock, a general rule of thumb is that it should have increased its payout at least once each calendar year for at least the past few years.

Categories of dividend growth stocks

Even though there's no official definition of a dividend growth stock, investors have assigned special designations for companies with a long history of increasing their dividends on an annual basis:

  • Dividend Challengers: U.S. listed stocks that have raised their dividends between five to nine consecutive years.
  • Dividend Contenders: U.S. listed stocks that have increased their dividends between 10 to 24 years.
  • Dividend Champions: U.S. listed stocks that have increased their dividends for more than 25 consecutive years.
  • Dividend Aristocrats: Similar to dividend champions in that they've increased their dividends for 25 straight years. However, to be an aristocrat, the company must be included in the S&P 500.
  • Dividend Kings: Companies that have raised their dividends for at least 50 straight years.

What sets the best dividend growth stocks apart?

Companies with a long history of increasing their dividends on a regular basis often share four common characteristics:

  1. They're mature businesses that produce consistent profitability and free cash flow.
  2. They have a healthy dividend payout ratio.
  3. They have a strong a balance sheet, often backed by an investment-grade credit rating.
  4. They still have a long growth runway up ahead.

While dividend growth stocks don't necessarily need to have all four characteristics, the best ones do tend to possess all four.

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Excess profitability

Young businesses that are growing fast often reinvest all their earnings, and then some, into expanding. They're using that cash to open new locations, build additional factories, or buy new equipment. Because of that, they don't have money to spare for dividends.

However, as businesses mature, cash flow frees up, enabling the company to start sending money back to investors through dividends as well as share repurchases. Some companies, especially in technology, prefer buybacks over dividends because of how dividend taxes impact investors and to help offset stock dilution. However, when a company initiates a dividend, it's a sign that it has confidence in its future and can remain profitable for years to come.

The dividend payout ratio

The dividend payout ratio is the percentage of a company's cash flow that it sends to investors each year. For example, if a company pulls in $1 million in profits, and pays out half of that money in dividends, its payout ratio would be 50%.

Payout ratios vary by industry and company. A business that's early in its growth cycle might opt to retain all its earnings and not pay a dividend so they can reinvest that money in the growing business. Meanwhile, a more mature company with limited growth prospects might decide to pay out a significant portion of its cash flow because it has the ability to do so and it incentivizes investors to buy its stock.

A payout ratio of more than 0% but less than 35% is a good range for dividend growth stocks because it means the company is retaining a significant portion of its cash flow for reinvestment, which should grow cash flow at a brisk pace and therefore, a company's ability to increase its dividend. However, even a payout ratio in the range of 35% to 50% can still be healthy because it should leave the business with ample excess cash for reinvestment purposes.

While there's no set rule on an ideal payout ratio, a study by Wellington Management found that companies with higher payout ratios -- with the average at 46% -- have outperformed the S&P 500 89.9% of the time since 1979. The study also found that even stocks with the highest payout ratios -- 70% on average -- outperformed the market 77.8% of the time. Meanwhile, those with lower payout ratios typically beat the market less than 50% of the time. The conclusion drawn is that companies with higher payout ratios tended to outperform. 

However, keep in mind that the higher the payout ratio the greater the risk for a dividend reduction during tough times. While payout ratios differ by industry, a good rule of thumb is to focus on companies that have payout ratios below 75% because that reduces the risk of a dividend cut.

The balance sheet

Another key characteristic of a great dividend growth stock is that the company has a solid financial foundation. Not only is the company's profitability increasing on a consistent basis, but it has the balance sheet strength and financial flexibility to weather tough times.

While there are many ways to measure a company's financial strength, two important ones to consider are its cash position and its credit rating. Companies that have built up a large cash balance will have the funds to continue paying their dividend even if market conditions take a turn for the worse. While optimal cash positions vary by company and industry, it certainly wouldn't hurt if it had enough cash in reserve to pay a year's worth of dividends.

Meanwhile, companies with investment-grade credit ratings have greater access to funding (and at lower rates) than junk-rated ones. That provides them with the ability to borrow money if needed to help bridge a cash flow gap if times get tough.

Growing earnings is key

Two factors drive a company's ability to increase its dividend. It can increase its payout ratio, or it can grow earnings. Companies with low payout ratios can continue raising their dividends for years even if profits have plateaued because they could keep increasing the percentage of income that they pay out. However, a company would eventually max out its ability to increase the dividend since it can't sustainably pay out more than 100% of its cash flow.

That's why companies with visible growth opportunities ahead of them make the best dividend growth stocks because they can grow cash flow, giving them more money to pay out in the future. In many cases, companies choose to increase their dividend at the same pace earnings rise. For example, if a company is paying out 30% of its cash flow in dividends and cash flow rises 10% each year, it could grow the dividend at that same 10% pace while maintaining a good payout ratio.

This characteristic is a bit harder to define because market conditions change on a dime. However, investors should look at things like a company's market share as well as industry growth forecasts. If a company already controls a significant portion of its addressable market -- the market share of the total revenue opportunity for a company's current products or services -- and that's not expected to grow much more, it has limited ability to increase earnings and the dividend in the future. Because of that, the key is to find companies with a large growth runway up ahead. 

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Two case studies in dividend growth investing:

1. Lowes (NYSE:LOW)

To illustrate the power of dividend growth stocks, we'll take a closer look at a home improvement giant Lowes, which has an impressive dividend history. The company, which has paid dividends since it came public in 1961, has earned the title of Dividend King after having raised its payout for 54 consecutive years. That steadily growing dividend has helped Lowes vastly outperform the S&P 500. Over the last decade alone, Lowes produced a total return of more than 315% while the S&P 500's total return has been just over 135%.

Lowes has achieved its dividend growth success by meeting all four characteristics of a great dividend growth stock through most of its history. That's still true today. Over the past five years, Lowes has grown earnings per share at a 21% average annual clip. Meanwhile, even after reinvesting capital to continue opening stores and expand its business, the company generated a whopping $19.2 billion in free cash flow. In 2017 alone Lowes produced nearly $5.1 billion in operating cash flow and reinvested about $1.1 billion in capital projects, which left it with $3.9 million in free cash.

Lowes currently pays out less 35% of its earnings in dividends, which is why its dividend yield is only slightly above the S&P's average at 1.9%. However, that conservative payout ratio leaves it with ample excess cash not only to reinvest in growing its business but to repurchase shares. The company bought back $3.1 billion in stock during 2017 and expects to repurchase $10 billion in shares by the end of 2019.

The home improvement giant also has an A-rated balance sheet, backed with a leverage ratio that's well within its target range. Further, it had more than $558 million in cash on the balance sheet. While that's not enough to fund a year's worth of dividends, given the company's cash flow, low payout ratio, and high credit rating, it's a more than adequate cushion.

Finally, Lowes still has room to grow. The company plans to add another 10 stores this year bringing its total count up to more than 2,400 locations, which will help increase sales 4%. Meanwhile, the total home improvement market stands at $850 billion, and Lowes currently has about a 10% market share, leaving it with ample running room. Because of that, Lowes has plenty of dividend growth potential up ahead. In fact, the company's current aim is to grow its dividend 15% to 20% annually over the next couple of years as earnings increase and the company pushes its payout ratio up to its 35% target.

2. Enterprise Products Partners (NYSE:EPD)

Lowes has been a wildly successful dividend growth stock over the years because it had all four of the characteristics typically found in the best dividend growth stocks. However, that doesn't necessarily mean that investors should automatically disqualify companies that don't meet all four standards since they are more general rules of thumb than absolutes. To drive that point home, we'll take a look at oil and gas pipeline giant Enterprise Products Partners.

Since going public in 1998, Enterprise Products Partners has increased its distribution to investors 64 times, including raising it in each of the last 55 quarters, which qualifies it as a dividend contender. That consistent dividend growth has fueled a stunning total return of 1,730% for Enterprise's initial investors at its IPO versus just a 260% total return from the S&P 500 over the same time period. One other noteworthy factor about Enterprise Products Partners is that it offers a much higher current yield than most other stocks at 6.1%. That's due in large part because it is a master limited partnership and therefore must distribute 90% of its reported earnings to investors. In exchange, the company pays no corporate taxes.

While Enterprise needs to pay out 90% of its profits to maintain its tax-advantaged status, cash flow for pipeline companies tends to be much higher than reported profits due to the negative impact that depreciation and amortization have on earnings. That's because pipeline companies are allowed to take a depreciation deduction on the investment made in new pipelines to reduce the taxable income that they'll pass through to investors. In the first quarter of 2018, for example, Enterprise's net income was $912 million. However, after adding back the depreciation expense, the company generated nearly $1.4 billion of distributable cash flow, which is the money it could have paid out to investors. While Enterprise only needed to distribute about $825 million of that cash to investors, it chose to send them roughly 75% of the cash flow it produced, or about $1.05 billion, which still left it with some excess to help fund expansion projects.

While that payout ratio is very high compared to most companies, it's much less than most other MLPs, which often pay out more than 90% of cash flow because they believe they can produce higher returns for investors by issuing more stock or debt to fund expansion projects instead of financing them with retained additional cash. However, Enterprise's more conservative approach versus peers has served it well over the years by providing the company with a good funding head start for expansion projects. In fact, the company recently took a step to retain even more cash going forward so that it can finance half the cost of future system expansions with internally generated cash flow while funding the balance with debt. The pipeline giant can easily afford those incremental borrowings because it has the best credit rating among MLPs.

Speaking of growth, there's plenty of that ahead for Enterprise even as renewables grow in importance. The company currently has $5.3 billion of expansion projects under construction, which provides investors with clear line-of-sight that the company's cash flow will continue rising through 2020. Meanwhile, North American energy companies need to invest roughly $26 billion per year through 2035 in expanding energy infrastructure to handle demand according to a study by the industry, which should provide Enterprise with ample opportunities to continue growing.

As Enterprise Products Partners' history shows, even companies with higher payout ratios can be excellent dividend growth stocks as long as they generate lots of cash, have strong financials, and ample growth coming down the pipeline.

Putting it all together

The best dividend growth stocks generate a mountain of cash each year, giving them plenty of money to grow their business and pay dividends. While there's no perfect number, companies that pay out between 35% to 50% of their cash flow in dividends should have enough left over to reinvest back into their businesses to deliver healthy earnings growth while also paying a worthwhile dividend. A balanced allocation like that has the potential to enable a company to grow earnings at around a 5% to 15% annual pace, while delivering dividend growth around the same rate, depending on the industry. Finally, a strong investment grade balance sheet and a nice cash cushion will provide the necessary margin of safety to enable a company to continue growing its dividend while reinvesting in its business during more challenging times.

It all comes down to understanding the company and doing sufficient due diligence. It's not an exact science since companies with weaker balance sheets or muted growth prospects could still be solid dividend growth stocks as long as they generate tons of cash and have low payout ratios, those that have all four characteristics tend to deliver healthy dividend growth for years on end. That growing income stream is often the fuel that gives these stocks the extra boost needed to outperform their stingier peers. 

 

Matthew DiLallo owns shares of Enterprise Products Partners. The Motley Fool recommends Enterprise Products Partners and Lowe's. The Motley Fool has a disclosure policy.