Dividend payers deserve a berth in any long-term stock portfolio. But, seemingly attractive dividend yields are not always as fetching as they may appear. Let's see which companies in the application software industry offer the most promising dividends.
Yields and growth rates and payout ratios, oh my!
Before we get to those companies, though, you should understand just why you'd want to own dividend payers. These stocks can contribute a huge chunk of growth to your portfolio in good times, and bolster it during market downturns.
As my colleague Matt Koppenheffer has noted: "Between 2000 and 2009, the average dividend-adjusted return on stocks with market caps above $5 billion and a trailing yield of 2.5% or better was a whopping 114%. Compare that to a 19% drop for the S&P 500."
When hunting for promising dividend payers, unsophisticated investors will often just look for the highest yields they can find. While these stocks will indeed pay out the most, the yield figures apply only for the current year. Extremely steep dividend yields can be precarious, and even solid ones are vulnerable to dividend cuts.
When evaluating a company's attractiveness in terms of its dividend, it's important to examine at least three factors:
- The current yield
- The dividend growth
- The payout ratio
If a company has a middling dividend yield, but a history of increasing its payment substantially from year to year, it deserves extra consideration. A $3 dividend can become $7.80 in 10 years, if it grows at 10% annually. (It will top $20 after 20 years.) Thus, a 3% yield today may be more attractive than a 4% one, if the 3% company is rapidly increasing that dividend.
Next, consider the company's payout ratio, which reflects what percentage of income the company is spending on its dividend. In general, the lower the number, the better. A low payout ratio means there's plenty of room for generous dividend increases. It also means that much of the company's income remains in its hands, giving it a lot of flexibility. That money can fund the business' expansion, pay off debt, buy back shares, or even buy other companies. A steep payout ratio reflects little flexibility for the company, less room for dividend growth, and a stronger chance that if the company falls on hard times, it will have to reduce its dividend.
Peering into software
Turning to the dividend growth rate, CA Technologies leads the way, with a five-year average annual dividend growth rate of 44% (due to a huge quintupling of its dividend this year). That growth rate is so steep, though, that it will be hard to maintain for long.
Some application software companies, such as Nuance Communications
As I see it, Microsoft offers the best combination of dividend traits, sporting some solid income now and a good chance of strong dividend growth in the future. Its yield was recently 2.5%, and is growing by an average of 11%. The company is sitting on tens of billions of dollars in cash and equivalents, too, boding well for future growth and dividend hikes. OPNET Technologies
Of course, as with all stocks, you'll want to look into more than just a company's dividend situation before making a purchase decision. Still, these stocks' compelling dividends make them great places to start your search, particularly if you're excited by the prospects for this industry. Remember, though, that you may find even more attractive dividends elsewhere, such as in foreign wireless companies or gas utilities.
Do your portfolio a favor. Don't ignore the growth you can gain from powerful dividend payers.
Looking for some All-Star dividend-paying stocks? Look no further.
Editor's note: A previous version of this article failed to note that China Digital TV has paid special dividends in the past. The Fool regrets the omission.