Investing in stocks with a history of growing dividends provides both a solid income stream and potential for capital appreciation. For most companies, the earnings per share (EPS) is the cash flow from which those dividends are paid. For a dividend to grow, it needs to be supported by EPS growth.
Earnings Per Share and Dividend
Most dividend-paying companies make dividend payouts quarterly to coincide with the required quarterly financial reports. Earnings per share refers to the net income a company earns after all expenses and taxes divided by the number of outstanding shares. When the EPS number is published, that amount can be compared to the quarterly dividend amount the company paid for the quarter. A common corporate goal is to produce an EPS that grows year after year. Seasonal effects may cause earnings to fluctuate from quarter to quarter. To get a more accurate picture of earnings, compare full-year results or compare the same quarter year-over-year (such as the second quarter of last year compared to the second quarter of this year).
Dividend Payout Ratio
The dividend payout ratio is the dividend amount divided by the earnings per share. The ratio can be calculated on an annual or quarterly basis. A lower payout ratio means the company has excess earnings for future dividend increases. If you are looking for long-term, sustainable dividend growth, comparing the dividend ratio over several years shows whether the EPS is growing fast enough to support the dividend growth rate. Large, stable companies with steady earnings growth can afford a higher payout ratio than companies with inconsistent EPS growth rates.
Adjustments to Earnings
You may find certain stocks with attractive dividend yields, but the payout ratio appears to be too high to sustain the dividend growth rate. A company may have non-cash expenses that do not affect the company's ability to pay dividends. Types of companies with this characteristic include telecommunications stocks, real estate investment trusts (REITs) and master limited partnerships (MLPs). With this type of company, look for the distributable cash flow instead of earnings per share. REIT companies refer to this as funds from operations (FFO) per share. These numbers can be used to calculate dividend payout ratios and evaluate dividend growth potential.
A history of steady EPS growth and Wall Street forecasts of future growth are the best indicators that a company can continue to grow its dividend payments. Remember that both future earnings and dividends are not guaranteed. Review the results of your dividend growth stocks on a regular basis to make sure the earnings growth is sufficient to maintain the dividend growth. A couple of quarterly earnings reports with slower- or lower-than-expected earnings are not a cause for immediate alarm, but indicate that a closer watch should be kept on the stock.
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