After attempting to cook dinner, you notice something very odd with your oven. Every time you set it to 400 degrees, it only heats up to 100. The display reads 400, but your under-cooked food suggests otherwise. You do this time and time again, and the same thing happens.
Here's my question: is your oven reliable?
According to researchers, yes. The problem, instead, is that your oven isn't valid. When you look at dividend stocks like Wells Fargo (NYSE:WFC) and Procter & Gamble (NYSE:PG), there's a small but important difference between "reliability" and "validity." To pick great dividend stocks you need to find businesses which show a mixture of the two.
Something's reliable if its results repeat over time. In terms of dividends, does the company have a history of consistently paying its dividend?
Wells Fargo stumbled a bit during the financial crisis, but overall I'd consider it to have a reliable dividend -- and this is especially true in comparison with similar-sized banks that had to cut theirs entirely. Procter & Gamble, however, has been incredibly reliable and it has steadily increased its dividend over the past 10 years.
Validity is considered a measure of objective truth. It can also be seen as the ability of a tool to accurately measure what it's supposed to measure. While the oven was reliable, it was far from valid in its ability to measure temperature. Dividends work in much the same way.
Here's how: since a company pays dividends from free cash flow -- or its cash generated after paying expenses -- think of dividends as a measure of how much free cash flow a company doesn't need to operate and grow its business.
Therefore, a dividend can only lose its validity in one of two ways:
- If the company is losing money consistently, or in a big way.
- If the company is growing its dividend without growing its free cash flow.
1. Is the company growing its cash flow?
While Procter & Gamble's cash flow is up over the last 10 years, its actually down nearly 20% over the last five. Wells Fargo's cash flow, despite its volatility, is up huge over the last five years. Equally impressive, over the last 10 years -- this includes the financial crisis -- Wells Fargo has grown cash flow faster than Procter & Gamble.
2. How much does the company spend on dividends?
The cash dividend payout ratio tells us how much free cash flow the company allocates to its dividend. A greater percentage means a greater risk that reduced cash flow could lower or plateau the dividend.
Here's where two very different stories collide. On the one side, Procter & Gamble has consistently grown its dividend although its free cash flow has stumbled over the last five years. It's been doing this for so long that more than 70% of the company's cash flow goes toward dividends. If this remains the case, it would seem nearly impossible for the company to continue to grow its dividend. If this comes to fruition, inflation will slowly eat into the dividend's buying power which will make it less and less valuable over time.
Wells Fargo, however, is using less than 11% of its free cash flow to supplement its dividends. Stack on top of that its consistently growing cash flow. Together, these things suggest that the company has plenty of cushion to support its dividend and more than enough cash flow to raise it over time.
The bottom line
When searching for great dividend stocks, whether a company has a history of reliably paying dividends is important. However, determining the sustainability of that dividend is of equal, if not greater importance. Ultimately, finding businesses that will grow over time is your best bet for finding stronger, more-sustainable dividend stocks.
Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool recommends Procter & Gamble and Wells Fargo. The Motley Fool owns shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.