With just days to go in 2022, the market has experienced a hard reset. Stocks are down, sure, but much more than that has happened. The Fed has been aggressively raising interest rates, bringing the end to an era of zero-interest rate monetary policy. Suddenly, investing in profitable businesses that pay dividends is back in style.
But bear markets are not the only time to be excited about dividend-paying stocks. Rather, companies that spin off increasing amounts of cash every year to their shareholders are a tried-and-true way to beat the market over the long term. In that light, three Fool.com contributors showcase rising dividend payments, free-cash-flow growth, and stock buybacks as excellent signals for investors to seek out if they want to dive into dividend investing. Here's why.
Sweet, sweet dividend growth
Anders Bylund (Dividend growth): Predictable dividend growth for the long haul is a key ingredient in an income investor's tool belt. In fact, many dividend investors simply won't touch a stock that doesn't come with a long history of annual dividend increases.
This quality is essential for many reasons.
- Dividends provide a robust income source, and a growing payout results in a more generous income stream every year.
- Next to share buybacks, it's one of the most direct ways a company can return excess earnings directly to their shareholders, and rising cash profits should lead to richer dividend payments.
- An unbroken streak of dividend boosts shows that the company runs an effective cash machine and doesn't mind sharing those profits with investors.
- It also serves as a vote of confidence by the board of directors, directing cash toward dividend payments instead of struggling to pay the bills.
Income investors really care about this idea. There are fancy names for stocks with multi-decade streaks of annual dividend increases. The Gordon Growth Model helps you pin a reasonable market value on any dividend-paying stock based on its ability to boost payouts over time.
For example, let's look at semiconductor veteran Texas Instruments (TXN -0.69%) -- a perennial favorite among long-term income seekers.
The company has raised its payouts for 18 years straight, including an 8% year-over-year boost in the quarterly check that was paid on Nov. 15. Based on that increase, Texas Instruments' annual payout now stands at $4.96 per share, which works out to an effective dividend yield of 3.0%.
Suppose you bought some Texas Instruments shares 10 years ago. The yield was 2.7% at the time, based on a quarterly payout of $0.21 per share and a stock price near $31. But if you're still holding those shares today, you can measure the annual payout of $4.96 per share against your original cost basis of $31 per share. In this light, your effective yield skyrockets to 16%.
Plugging Texas Instruments' dividend growth data into a Gordon Growth calculator, with a 10% discount rate and a constant dividend increase rate of 8%, suggests the stock should be worth roughly $268 per share. That's 58% above the current share price, indicating the stock is undervalued compared to its robust dividend growth.
The fact the chipmaker recently announced yet another payout boost in the midst of a macroeconomic crisis only underscores its financial heft. This stock can serve as a robust cash-generating income asset for decades to come.
Data by YCharts.
A key profitability metric when measuring dividend payout potential
Nicholas Rossolillo (Free cash flow): When searching for top dividend stocks, free cash flow is a top metric to focus on. Many investors look at net income and use it to calculate the payout ratio when assessing a dividend stock. However, net income includes non-cash expenses like depreciation and amortization, as well as stock-based compensation paid to employees. It may also capture non-recurring sources of profit like if a company sells assets. Thus, net income isn't the best way to measure a company's ability to return excess cash to shareholders.
That's where free cash flow comes in. To be clear, free cash flow is not a generally accepted accounting principle (GAAP) metric like net income is. It's considered an "adjusted" or "non-GAAP" profit metric, and there are a few ways free cash flow can be calculated. But in most cases, free cash flow is quite simple: It's measured as "cash generated from operating activities" minus "capital expenditures" (or CapEx, money spent on big purchases like property and equipment).
Because a company's operations can be variable and the cadence of CapEx can swing wildly from one year to the next, free cash flow tends to be much lumpier than net income. Nevertheless, free cash flow is the better indicator of a company's ability to pay dividends. A company that can grow free cash flow over the long term tends to be one that increases its dividend payout. And a company that generates high levels of free cash flow can additionally repurchase stock to further enhance shareholder value (more on this later).
See semiconductor industry titan Broadcom (AVGO -4.42%) as an example. While it doesn't put up flashy growth numbers like other top chip stocks, Broadcom has had an impeccable run generating free cash flow over the last decade.
In 2022, Broadcom generated a free-cash-flow profit margin of 49%, a remarkably high figure that isn't an anomaly. Broadcom has been putting up a free-cash-flow margin of at least 40% for years.
While other technologists funnel lots of cash into research and marketing the latest and greatest silicon designs, Broadcom focuses on oft-overlooked niches within the chip world it can dominate and maximize profit on. The parallel between the company's free-cash-flow growth and dividends paid is undeniable and has led to fantastic returns for owners of the stock.
Data by YCharts.
Broadcom shares are up over 2,100% over the last 10 years alone when including dividends paid. It's an excellent example of how free cash flow feeds into dividend growth stories and why dividend stock investors should focus on this critical profitability metric.
Look at dividends plus buybacks for a "true" yield
Billy Duberstein (Share buybacks): One underappreciated aspect of dividend stocks with less-than-stellar current yields is the possibility of the company repurchasing their stock in large quantities. That's because stock buybacks can greatly enhance overall returns and dividend growth on an ongoing basis.
In fact, while Warren Buffett's conglomerate Berkshire Hathaway has never issued a dividend, Buffett has frequently resorted to share buybacks as his preferred way of returning cash to shareholders. When a company repurchases stock, it lowers the overall share count, increasing each remaining shareholders' ownership of that business.
What's even better is that share buybacks have tax advantages over dividend payments, which are taxed at the marginal income tax rate if it's an ordinary dividend. This has changed a bit with the recent passage of the Inflation Reduction Act, which will tax corporations of a certain size on their share buybacks at 1% from 2023. Still, that's a relatively low amount and likely shouldn't affect the buyback behavior of most companies.
So the tax advantages of buybacks over dividends are another reason not to focus exclusively on dividend yields. The total shareholder yield of dividends plus buybacks may be a more useful way to look at dividend stocks, and it could make one think twice about which stocks to invest in.
Buybacks are also flexible, and management can adjust their repurchase activity up and down according to the economic cycle and the company's share price. While it's possible for management teams to waste a lot of money on buybacks at too high a price, as happened with Bed Bath & Beyond, a management team that buys back stock opportunistically can create tremendous value if shares are repurchased below their intrinsic value.
Well-executed buybacks also provide the opportunity for even better long-term dividend growth. For instance, if a company pays just a 2% dividend but repurchases 5% of its shares in a year, it would theoretically be able to raise its dividend 5% per share the following year, even if it doesn't grow net income or raise its overall payout ratio.
Last week, I discussed Lam Research (LRCX -2.94%) as a current favorite dividend growth stock. Over the past five years, Lam's trailing-12-month operating income has improved about 120%, but its dividend per share has skyrocketed about 240%. Dividend growth outpacing profit growth is partially a function of a slightly higher payout ratio, but the 16% reduction in shares outstanding over that time period through well-timed buybacks is also playing a big role as well.
For those focused on the long term, you may not want to look exclusively at a company's dividend yield but rather the total shareholder yield with buybacks included. Even if the dividend yield is low today, if the company is growing and repurchasing stock, that dividend payout can grow by leaps and bounds over a span of five or 10 years.
