How I'm Grabbing 20% Dividend Yields

The market's now full of exciting dividend yields. Among dividend-paying companies listed on U.S. stock exchanges, more than 1,300 -- over 40% of the total -- recently sported yields above 5%.

But when yields are unusually high, you often can't trust them. In a market like this, littered with dividend reductions galore, it can sometimes be hard to predict whether a company's future earnings will support future dividend payments. And if they won't, well, those high dividends are likely to end up on the cutting-room floor.

Even the long-term dividend payers aren't immune. Wells Fargo, Dow Chemical, Motorola, Pfizer, and International Paper have all cut their dividends lately -- all of them stable, long-term blue chips.

Don't despair, though, because there are still ways to achieve high dividend yields relatively safely.

Dividends rising
See, over time, stock prices increase, and ideally, dividend payouts increase as well. But your cost basis doesn't change, no matter what else happens with the stock. And that means that even if a company is paying out 3% compared to today's stock price, it's paying out far more, relatively speaking, to those who bought the stock for much less, many years ago.

McDonald's, for example, was recently paying out $2 a year per share in dividends. That's a 3.6% yield if you buy now, when the price is around $55. But I bought it nearly three years ago, when the price was around $37, and that gives me a 5.5% yield on my cost.

If McDonald's increases its dividend by 12% per year on average, in 12 years it would be paying out nearly $8 per share, giving me a 22% yield. In just 15 years, my effective yield would be a whopping 30%! And this is all separate from whether the stock itself appreciates.

So, while the current yield on a stock might be only 2% or 3%, that's for people buying the stock right now at the current price. For those who bought it long ago at lower prices, and who are getting that same dividend, their effective yield is higher. And over time, it can grow very high indeed.

Why it matters
Healthy, growing companies have more going for them than dividend increases. Over the long term, their share prices also tend to rise.

McDonald's, for example, has averaged 20% growth over the past five years, and its dividend has grown by an average of roughly 30% over the past five years -- even factoring in the last terrible market year.

That combination of strong stock growth and reinvested, growing dividends is what has made companies like Altria the best-performing stocks of the last half-century, according to Wharton professor Jeremy Siegel. That's the power of dividend growth.

While growing dividends and healthy, effective yields boost portfolios in any market, they're especially helpful in markets like this one, because solid dividend payers keep paying you no matter what the economy is doing.

Remember, though, that hard times can also make it challenging for some companies to keep paying their dividends. That's why it's always critical to choose firms that are particularly healthy and stand little chance of reducing or eliminating their dividend.

How to find healthy companies
To zero in on healthy companies with growing dividends, look for relatively little debt and relatively robust cash piles (via the balance sheet). Also look for growing revenue and income, and ideally, rising profit margins, too. Be wary when accounts receivable or inventories are growing faster than sales.

I used those general guidelines to screen for large-cap companies with dividend yields of 2.5% or more, five-year average annual dividend growth rates of 8% or more, five-year average annual revenue growth rates of 8% or more, and price-to-earnings (P/E) ratios of 20 or less:

Source: MSNMoney.com.

These aren't recommendations, but they are ideas you might want to research further.

Just as you should be wary of high yields, be wary of super-high dividend growth rates. Sometimes they're there because a company had a one-time payout or because the company has been quickly ramping up from being a non-dividend payer to being a significant payer. Energy company EnCana, for example, went from paying $0.05 per quarter in 2002 to $0.40 per quarter in 2008, an eightfold increase.

Don't expect growth rates like EnCana's 51% from most companies, especially not over the long term. You'll see them sometimes, when a company has a period of aggressive dividend growth, but over the long run, growth rates of 10% to 15% are far more sustainable -- and thus more dependable, even as they turn your current 3% yield into double digits in just a few years.

High yields you can count on
In markets as volatile and unpredictable as this one, it's good to remember that long-term dividend growth can be a better contributor to long-term portfolio growth than a high yield alone.

So, if you want 20% yields, look for companies that have a history of increasing dividends as well as the probability of long-term capital appreciation. It will take a few years, but you'll be better able to count on that yield -- just like I'm expecting to enjoy 20% and 30% effective yields on my investment in McDonald's.

Quality, long-term dividend growers are the kind of companies we look for at Motley Fool Income Investor. If you'd like to see what we're recommending now, just click here for a free, 30-day trial.

Already subscribe to Income Investor? Log in at the top of this page.

This article was originally published on May 11, 2009. It has been updated.

Longtime Fool contributor Selena Maranjian owns shares of McDonald's and Coca-Cola. General Dynamics, Coca-Cola, and Pfizer are Motley Fool Inside Value recommendations. Coca-Cola is a Motley Fool Income Investor pick. CNOOC is a Motley Fool Global Gains selection. The Motley Fool is Fools writing for Fools.