One of my favorite ways to get a feel for a stock's dividend potential is to take its dividend yield and divide that by its payout ratio. This calculation shows the maximum yield possible if a company were to pay out all the profit generated each quarter.
While highly unscientific, this little thought exercise can be a great way to find stocks that pay healthy dividends and are paired with lower payout ratios -- thus, identifying companies with high dividend potential. When talking about "healthy" yields with regard to dividend growth investing, I generally mean stocks that do two things: increase their dividend each year and have a payout ratio below 50%.
Together, these two items show a balance between returning cash to shareholders and funding growth within the company, which has led to jaw-dropping dividend returns for investors over the long term. Today, we will look at two value companies that beautifully fit this healthy dividend mold and are available to investors at cheap valuations.
1. Kroger: Max dividend yield of 4.2%
First up is a stock that Warren Buffett and his holding company, Berkshire Hathaway, have been buying up stock in over the last year, and that is Kroger (NYSE:KR). After picking up a handful of new shares, Buffett and his company now hold roughly $2.4 billion of the grocer's stock, hinting that they see better days still to come.
Kroger currently has a 2.01% dividend yield and its payout ratio is 47.7%. While Kroger's max dividend yield calculates to only 4.2%, its free cash flow (FCF) generation is probably the key figure to look at regarding dividend safety. Guiding for $2 billion in FCF for 2021, the grocer could triple its current $0.84 per-share annual dividend and still have a little cash left over from its operations.
Furthermore, with the company trading at an enterprise value to earnings before interest, taxes, depreciation, and amortization (EV/EBITDA) of 9, its shares are still relatively cheap despite its dividend growth potential. Compared to the S&P 500 consumer staples average EV/EBITDA of 16.5, Kroger stock is trading at a deep discount.
Operationally, Kroger looks more robust than ever, not only surviving the pandemic but also building strong digital sales, which grew 114% over the last two years. Aiming to double its digital sales by 2023, the rapidly expanding unit provides priceless engagement with its customers and allows the company to build a robust database of preferences about its shoppers.
Considering that Kroger's personalization service recommended 60% of the items in customers' digital baskets, it is clear the company understands what its shoppers are looking for -- a compelling skill for any grocer.
All in all, Kroger's cheap valuation, promising digital sales, 15 years of consecutive dividend increases, and overall dividend potential make it a promising investment opportunity for yield-focused investors.
2. FedEx: Max dividend yield of 8.1%
Raising its dividend by 15% to $3 per share annually in June of 2021, FedEx (NYSE:FDX) put itself back on the dividend growth investing radar after pausing its increases for two years. Despite having a dividend that only yields 1.2%, FedEx boasts strong dividend potential as its payout ratio is a minuscule 15%. This is especially true considering it has grown its dividend payout by an average of 17% annually since 2004 -- even with the recent pause.
Owning just over a 30% share of the U.S. ground market for packages, the company's low EV/EBITDA of 8.4 should be pretty attractive to investors. Considering the company's largest competitor, United Parcel Service (NYSE:UPS) has an EV/EBITDA of 16.4, both FedEx's sales growth of 9% annualized over the last three years and its shares seem attractive.
Furthermore, despite the massive amount of capital needed to support its giant global network, FedEx's profit margin of nearly 6% is not only quite impressive but also in line with UPS's figure of 7%.
From a bigger-picture point of view, FedEx has positioned itself beautifully to continue capturing the broad expansion from rising e-commerce sales, which are expected to grow by 17% in 2021 to $4.9 trillion -- despite having grown 26% during the pandemic in 2020.
This massive growth driver, paired with the company's nearly complete integration of its TNT acquisition from 2016, has management guiding for earnings per share growth of 10% to 15% annually for the long term. While this may be a bit ambitious and, undoubtedly, will be lumpy over time, delivering anything close to this growth at today's valuation would be a homerun for shareholders.
Ultimately, thanks to FedEx's valuation, the undeniable growth trend in e-commerce, and its recent renewal of dividend increases, the company offers massive dividend potential to investors looking for a core, stable holding.