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 -- greater than 40% of the total -- recently sported yields exceeding 5%.

But you often can't trust unusually high yields. In a market like this, littered with dividend reductions galore (and more dividend cuts on the way), it can sometimes be hard to predict whether a company's future earnings will support its forthcoming 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, General Electric, and US Bancorp have all cut their dividends lately -- even though all of them have long been viewed as solid blue chips.

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

Dividends rising
Over time, stock prices increase; ideally, so do dividend payouts. But your cost basis doesn't change, no matter what else happens with the stock. Even if a company is paying out 3% compared with 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 (NYSE:MCD), for example, is paying out $2.20 a year per share in dividends. That's a 3.4% yield if you buy now, when the price is around $64. But I bought it nearly three years ago, when the price was around $37. That gives me a nearly 6% yield on my cost.

If McDonald's increases its dividend by 12% per year on average, in 12 years it would be paying out about $8 per share, giving me a 22% yield. In under 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. Those who bought it long ago at lower prices, and who now get that same dividend, enjoy a higher effective yield. And over time, that yield 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 18% 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 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 companies that are particularly healthy and stand little chance of reducing or eliminating their dividend. (And it's also why some people are saying that now is the right time to load up on dividends.)

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

I used those general guidelines to screen for companies with dividend yields of 2.5% or more, returns on equity of 15% or more, and price-to-earnings (P/E) ratios of 20 or less:

Sources: DividendInvestor.com and Capital IQ, a division of Standard & Poor's.

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

Just as you should be wary of high yields, you should also steer clear of super-high dividend growth rates. Sometimes a company has a one-time payout, or has quickly ramped up from paying little or no dividend to a very generous payout. McDonald's, for example, hiked its dividend by 33% a few years ago, which contributes to the fast-food giant's 32% five-year growth rate. Don't expect that impressive growth to continue for too long. (Indeed, the company's last dividend hike was a much lower, but still solid, 10%.)

You can't expect super-steep growth rates from most companies, especially 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, while 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.

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

Longtime Fool contributor Selena Maranjian owns shares of McDonald's, PepsiCo, Johnson & Johnson, and General Electric. AFLAC is a Motley Fool Stock Advisor selection. Diageo, Johnson & Johnson, and PepsiCo are Motley Fool Income Investor selections. The Motley Fool is Fools writing for Fools.