Dividend Growth All-Stars

When last I delved into investing for dividends, I focused on their significance in a portfolio for the steady stream of cash they provide in good times and bad. In that article, I walked through an example of a healthy 3% dividend and its powerful effect on a portfolio as it grows 8% a year.

Today, I'd like to look at the other end of the spectrum: companies with slightly lower yields but larger dividend growth potential.

In my personal portfolio, the bottom line on making a purchase or taking a pass is whether I believe the potential total return will beat the market. But I also try to balance a dividend stalwart such as General Electric (NYSE:GE), which I expect to raise its dividend by 7% to 10% per year, with companies that have small dividends today but should be able to grow their dividends much more quickly, such as Microsoft (NASDAQ:MSFT) or PetSmart (NASDAQ:PETM).

Mining for historical growers
I screen for dividend growers in two ways. The first is to look for companies that historically grow their dividend payments. The second entails searching for companies that generate plenty of free cash flow (FCF) and are likely to begin paying dividends. The best candidate, however, is a company that's shown a history of raising its dividend and has plenty of room to grow its payout.

In the table below, I've taken this hybrid approach and screened for companies with a dividend compound annual growth rate (CAGR) of more than 12% over five years and currently have a payout ratio of less than 50% of FCF.

While PepsiCo's dividend growth rate lags a bit behind the rest of the group, the company has increased its dividend by 18% per year for the past three years. Also, the relatively low yields in the table are common for companies with a greater propensity for dividend growth. That's partly because investors have priced in their growth expectations for these companies and because they pay out a relatively low portion of their FCF. However, note that when Alltel was recommended by our Income Investor newsletter service in January 2004, it yielded more than 3%, and there were opportunities this year to purchase PepsiCo with a yield of more than 2%.

Dividend growth at work
OK, that's the historical aspect of dividend growth. Let's take the next step and look at how powerful dividend growth can be by using PepsiCo as our example. Five years ago, PepsiCo paid $0.58 per share in dividends and traded for about $41 a share. Right now, it sells for $58 a share and will pay $1.04 per share in dividends. The logical question is: "How much will PepsiCo pay in dividends five years from now, assuming it continues to increase its dividend by 12.2% per year? Figuring that out requires some math, but nothing so daunting that it can't be worked out quickly on a calculator.

To figure out a potential future dividend in, say, five years, take the current dividend and multiply it by (1 + dividend growth rate) to the fifth power. Using this equation, we can estimate that PepsiCo's dividend in five years should be approximately $1.85 if the 12.2% growth remains constant -- $1.04 times (1.122) to the fifth power, which equals $1.85).

In real money terms, an investor who purchased 100 shares of PepsiCo five years ago would have received $58 in dividends in year one and will receive $104 in dividends this year. Over the entire five-year period, a total of $370 in dividends were paid. And if the growth rate remains constant over the next five years, PepsiCo's payout should be approximately $185 five years from now. Totaling all of the dividends over the entire 10-year period works out to $1,114 in dividends received on an original investment of approximately $4,100 (100 shares at $41).

Since PepsiCo is a healthy growing company, it's fairly safe to say that there should be substantial capital gains on top of the $1,114 in dividends (already $1,700 worth for a total annualized return of 8.5% -- versus a broader market that has actually lost value over the same timeframe).

Foolish final thoughts
When investing in dividend-paying companies, it's important to strike a balance between the dividends being paid today, the potential for far larger dividends in the future, and the company's current value. Chief Income Investor analyst Mathew Emmert scours the market each month for companies that strike that balance. His Alltel pick has beaten the market by 23 percentage points with a total return of 37%. But Alltel is just one of 29 Income Investor recommendations that have beaten the market. If you'd like to see this month's new selections, which were just released yesterday, click here for a free trial. With the trial, you'll also get access to detailed updates on each company and our dedicated Income Investor discussion boards.

Nathan Parmelee owns shares in Microsoft and PetSmart but has no financial stake in other companies mentioned. PetSmart is a Motley Fool Stock Advisor recommendation. The Motley Fool has a strict disclosure policy.