Growth Rules

There isn't much of a chill in the air around Fool HQ, but the school buses are running and the Red Sox are making my heart skip beats, so it must be fall. And school is back in session here at the Fool as well. After our recent "Back to Dividend School" articles, "Why Dividends?" and "Better Total Returns" by my Foolish colleagues Tim Beyers and Nathan Slaughter, I'm here to tackle the subject that is the most fun: growth.

Yup, that's right: Income investing is also about being in tune with growth. And not just sales and earnings growth, but past and potential dividend growth, too.

The dividend growth train
The best bang for the buck in dividend-paying stocks comes from companies that offer both an attractive yield at the time of purchase and the room to grow their dividends substantially over time. This is a large part of the success that long-term investors have enjoyed in such companies as General Electric (NYSE:GE), Johnson & Johnson (NYSE:JNJ), and PepsiCo (NYSE:PEP).

How does dividend growth play out for investors? I'm glad you asked. Let's look at SYSCO (NYSE:SYY), the food distribution company (not the network equipment maker), as an example.

SYSCO Dividend Growth

Source: SYSCO.com; 1999 dividend was $0.20
*Estimate based on three quarters of dividend payments

A few things stand out in the numbers. First, SYSCO seems committed to raising its dividend annually. Second, its dividend growth rate is slowing. To assume dividend growth next year based on the past is a little like assuming it will snow more than average in January because of past above-average snowfall. While that may happen, it also may not. Luckily, companies are a bit easier to gauge than the weather, regardless of what The Old Farmer's Almanac says.

What about the future?
The best way to figure out whether a company can continue to raise its dividend is a two-step process. Determine a company's payout ratio (how much of the company's earnings or free cash flow is currently paid out as a dividend) and determine whether the company has opportunities left for future earnings growth.

There are a number of ways to evaluate a company's payout ratio. Some investors use earnings per share divided by dividends per share or net income dividend by total dividends paid. Both of those methods should yield the same answer. My preference is to use free cash flow divided by total dividends paid.

I use free cash flow instead of net income because accrual accounting allows a fair amount of leeway for management estimates when it comes to matching revenues and expenses. In the hands of a conservative management team, this can be a non-issue, because the revenues and expenses will match up correctly or even conservatively. There are, however, plenty of examples where management gets aggressive and recognizes revenue early or delays the recognition of expenses. This causes net income and earnings per share to be overstated and can make a dividend look well funded when it really isn't. Free cash flow can also be manipulated, though not as easily. (Here's why free cash flow matters.)

The mechanics of calculating a company's payout ratio are very simple. Just some addition, subtraction, and division and all of the data is on the statement of cash flows. First, determine a company's free cash flow by taking operating cash flow and subtracting capital expenditures (free cash flow = operating cash flow - capital expenditures). You can refine free cash flow a bit further (which I recommend) by also subtracting tax benefits received from stock options and cash paid for acquisitions from operating cash flow.

Once you have free cash flow calculated, take that total and divide it into the amount of dividends paid, which is also a line item on the statement of cash flows (payout ratio = dividends paid/free cash flow). To save time, I have used the basic method of calculating free cash flow for SYSCO in the table below.

SYSCO Free Cash Flow and Payout Ratio ($ in Millions)

Source: Capital IQ

Like retailers Gap (NYSE:GPS) and Abercrombie & Fitch (NYSE:ANF), SYSCO pays out less than 50% of its free cash flow as dividends, which points to its ability to easily fund an increase in its dividend. It's also important to note that free cash flow doesn't follow a nice upward trend and that this is normal. For that reason, it often makes sense to calculate free cash flow using the average of three or more years.

Foolish bottom line
Dividend growth and a company's ability to fund its dividend are two of the more important metrics to consider when investing in a dividend-paying company. Together, the tools can quickly help you separate a company that may have trouble funding its dividend, such as Dana (NYSE:DCN), from the likes of Intel (NASDAQ:INTC), which funds its dividend easily.

Along with a yield of more than 3%, dividend growth and the payout ratio are two of the most important measurements for chief analyst Mathew Emmert when he reviews a stock for consideration in our Income Investor service. As a general rule, only companies that pay out less than 85% of their free cash flow in dividends make the cut. For many industries, we like to see that number quite a bit lower.

If you're interested in learning more about companies that generate robust free cash flow and can effortlessly fund their dividends,consider a30-day free trialto Motley Fool Income Investor. For more than two years, Income Investor selections have delivered a total average return of 13.6% against the S&P 500's 7.8%. There's no obligation to buy if you aren't completely happy.

NathanParmelee owns shares of Gap. You can view his profile here. The Motley Fool has an ironclad disclosure policy.