Dividends are a fantastic avenue for investors to build wealth in the stock market over the long term. However, when most investors hunt for dividend-paying stocks, they focus on the wrong criterion: dividend yield.
A high dividend yield may look appealing, but it can also signal business distress and a potential future cut of said dividend. Instead, investors should look for dividend stocks in the same manner as Warren Buffett, who is known to focus on attributes such as business quality, free cash flow growth, and a reasonable valuation.
If you follow these three rules and show patience, you can build a portfolio of "forever" dividend payers.
Image source: The Motley Fool.
Searching for competitive advantages
The first thing Buffett looks at when hunting for buy-and-hold stocks are competitive advantages. These are the elements of a high-quality business that give it an edge over competitors, leading to pricing power and earnings growth. In turn, that fuels dividend growth.
Let's take a look at Coca-Cola (KO 0.60%) as a prime example, one of Buffett's long-term holdings. Its namesake Coca-Cola product has unmatched brand strength in the beverage category, and the company has a large portfolio of other popular drinks too. It also has a global distribution advantage, getting its products front and center for customers and giving it economies of scale. Taken together, Coca-Cola has strong pricing power and scaled efficiencies that have enabled it to grow its dividend per share every year since Warren Buffett initially bought the stock in the 1990s. As of June 30, his company, Berkshire Hathaway, holds 400 million shares of Coca-Cola, one of its biggest positions.
NYSE: KO
Key Data Points
Growth in free cash flow leads to dividend growth
In order to pay a dividend, a company needs a balance sheet with plenty of cash. How do you pile up cash? By generating free cash flow, of course.
One way to sustainably grow a dividend payout is to increase free cash flow per share, which is the amount of cash a company generates from its core operating activities, less any capital expenditures. Strong and growing free cash flow indicates a company's ability to sustainably pay and increase dividends, which explains why Buffett looks for businesses with robust cash generation when identifying stocks to buy.
Let's look at another Buffett stock -- Apple (AAPL +0.28%) -- to illustrate this dynamic. Apple's free cash flow per share has increased 132% in the last 10 years. Its dividend per share is up 100% over that same time frame.
Another important factor to look at is the gap between free cash flow per share and dividend per share. Generally, you want a comfortable margin between your free cash flow per share and dividend payout. Apple's free cash flow per share of $6.37 is significantly higher than its annualized dividend per share of $1.04, which gives Apple plenty of room to keep growing its payout while still reinvesting in its business. The company is also reducing its outstanding share count through share buybacks, which will increase long-term free cash flow per share and make the job of growing the dividend per share easier.
Data by YCharts.
Start with a cheap price
With any investment, Buffett is looking to pay a price that represents a discount to the stock's intrinsic value. A lower price-to-earnings ratio (P/E), for example, will give a stock a higher earnings yield or free cash flow yield.
Even if a stock has a low dividend yield to start, a high earnings yield (relative to its peers, sector, or the market overall) will give it the capacity to increase its dividend over time. For a "forever" holding, consistent payout growth can result in a very high yield based on your initial purchase price.
Look beyond high yields alone when hunting for dividend stocks. Find a strong business with consistent payout growth at a reasonable price, and the dividend should take care of itself.
