When making investment decisions for the long term, focusing on high-quality dividend stocks can do wonders for your portfolio. Let's look at three key reasons to love dividend stocks, using examples from rock-solid dividend names such as Procter & Gamble (NYSE:PG), Disney (NYSE:DIS), and Apple (NASDAQ:AAPL).
1. Dividends provide transparency
Unlike earnings, which can be easily manipulated by management using accounting tricks and other gimmicks, dividends are far more transparent. Dividends are paid in cold, hard cash, which means that a company needs to be able to produce growing cash flows over the years if its going to build a sustained track record of dividend growth.
Procter & Gamble has paid dividends every year since 1890 and has impressively raised its dividends for the past 58 years in a row.
It takes a extraordinarily strong business to sustain that kind of performance over the decades, and Procter & Gamble is in fact one of the most solid and reliable dividend stocks in the market. The company sells mostly everyday necessities, as opposed to discretionary products, which allows Procter & Gamble to produce growing cash flows through good and bad economic times.
Also, competitive strengths are unquestionable, Procter & Gamble owns 23 brands making more than $1 billion each in global sales. Scale advantages, abundant financial resources to invest in marketing and advertising, and a gigantic distribution network are additional sources of competitive advantage protecting Procter & Gamble from the competition.
Dividends don't lie. When sustainable, a long and consistent trajectory of dividend growth is a reflection of a solid business generating tons of cash flows on recurrent basis.
2. Dividends can be a great valuation tool
Dividends also can be a simple and powerful tool to asses valuation. Procter & Gamble stock is trading near historical highs, so many investors could feel reluctant to buy at record prices. However, comparing price versus dividends can provide a much more enlightening perspective.
While Procter & Gamble stock has delivered big gains over the past 10 years, dividends have actually outgrown price. The stock is currently trading at a dividend yield of 2.8%, higher than the dividend yield for the average company in the S&P 500 Index, in the area of 2.1%, according to data from Morningstar.
Based on these considerations, we could hardly say that Procter & Gamble is overvalued, even if it's trading at record highs.
There are many different tools and ratios that investors can use to analyze valuation, but dividend yield is a unique measure, since it represents fresh cash deposited into your brokerage account on a regular basis. Stock prices can fluctuate for a variety of reasons, and volatility is almost impossible to predict. But the dividend yield tells you the return you're getting in cash dividends, substantially reducing uncertainty.
3. When dividends talk, investors should listen
Dividends convey a lot of information about the strength of a business and the degree of confidence management has on the future. Even if a company doesn't have a particularly long trajectory of dividend growth, rapidly growing dividends are generally a big positive signal for investors.
Disney raised dividends by a whopping 34% in December. CEO Robert Iger explained in the press release that such a generous dividend increase was based on the company's healthy fundamentals and strong business momentum:
Disney delivered the highest results in its history in fiscal 2014, reflecting the extraordinary quality of our creative content and the unparalleled strength of our brands. We achieved record revenue, net income, and earnings per share for the fourth year in a row, and we are delighted to be able to increase our shareholder dividend by 34% while continuing to invest for future growth.
Keeping these considerations in mind, it's no wonder Disney stock has delivered an extraordinary total return of more than 220% through the past five years. As long as the company continues producing record financial performance and rapidly growing dividends, investors in Disney stock can remain reasonably optimistic.
Applying the math
Unlike Disney and Procter & Gamble, Apple's dividend yield is a modest 1.8%. In this case, investors should examine the dividend in conjunction with other factors, like historical performance and cash flow.
The company reinstated dividends in 2012, so it doesn't have the same immaculate track record of dividend payments. However, Apple has more than $155 billion in cash and liquid assets on its balance sheet, and the business produced a massive $50 billion in free cash flows through the year ended in September 2014. Dividends absorbed only $11 billion during the year, so Apple has enormous room to continue increasing dividends in the future.
In this context, Apple may not be one of the most renowned dividend stocks in the market, but the company seems to be clearly on its way to building an extraordinary track record of dividend growth.