Payout Ratio: A Flexibility Test For Dividends
These are heady times for income-oriented investors, with an increasing number of large-cap stocks paying — and raising — dividends.
• Today, 85% of S&P 500 Index companies pay a dividend, the highest since 1997.
• During the 11 months ended November, 346 stocks in the S&P 500 had raised their dividends, 18% above the average over the last 10 full years. Only once during that decade (2013) did we see more hikes for a year.
• 2014 is shaping up to be the fifth straight calendar year with index stocks averaging dividend hikes of 20% or higher.
Given the recent stretch of dividend growth, investors should consider companies' capacity for future hikes. One such gauge is the payout ratio, which divides the indicated annual dividend into earnings per share over the last 12 months, or trailing EPS.
A payout ratio of 100% means a company returns all of its earnings to shareholders through dividends and implies little flexibility to deal with anything beyond the dividend. We typically prefer payout ratios below 50%, which provide the latitude to fund growth investments or handle a business slowdown without sacrificing the dividend or cutting back in other strategic areas, such as stock buybacks, capital investments, and acquisitions.
Five years of strong dividend growth have pushed the median payout ratio for S&P 500 dividend payers to 36%. That is close to its highest point since early 2010, when many companies began to resume dividend growth and trailing 12-month earnings still included the recession's contraction.
The capitalization-weighted S&P 500 Index's dividends for the 12 months ended September accounted for 34% of earnings for the same period, below the 20-year median of 35% and the 50-year median of 44%.
Payout ratios for most S&P 500 companies look reasonable. Just 20% of the index's dividend stocks have payout ratios above 50%, while 8% are above 75%.
We review four of our favorite dividend stocks below.
Aetna ($90; AET) earns an Overall score of 92, driven by Value and Quality ranks that exceed 80. The Momentum score of 62 is also solid, reflecting steady growth in several key areas. Aetna's earnings per share, revenue, and cash from operations are all up more than 15% over the past 12 months. All three metrics have risen in at least three of the past four quarters. Free cash flow, totaling $2.98 billion, nearly doubled during that stretch.
Aetna is quick to put its excess cash to work through a combination of acquisitions and other strategies to juice shareholder returns. Stock buybacks have lowered the share count 43% over the past decade, with Aetna paying an average price of less than $46. Last month, Aetna announced an 11% dividend hike. Aetna has raised its dividend by double-digits every year since moving to a quarterly distribution cycle in 2011. Aetna, yielding 1.1%, is a Buy and a Long-Term Buy.
Asset manager Ameriprise Financial ($133; AMP) operates in an industry that requires little capital investment. In the first nine months of 2014, Ameriprise returned $1.4 billion, or 112% of operating earnings, to shareholders through dividends and stock repurchases. During that period, the quarterly dividend rose 12% and the share count fell 4%. Ameriprise expects 2014 to be the fourth consecutive year in which it returns more than 100% of operating earnings to shareholders.
A continuation of solid operating momentum should help fuel future dividend growth. Sales, up at least 9% in six consecutive quarters, are projected to rise 7% in 2015. Equally important, free cash flow jumped 113% to $1.57 billion in the first nine months of 2014. Ameriprise, yielding 1.7%, is a Focus List Buy and a Long-Term Buy.
CVS Health ($89; CVS) has raised its quarterly dividend more than 10% in eight straight years — and more than 20% in each of the past four. CVS appears positioned for another big dividend increase, considering free cash flow rose 11% to $2.31 billion in the first nine months of 2014. Management raised its full-year guidance for free cash flow in November, implying additional growth in the December quarter. CVS tends to announce dividend hikes in December.
CVS expects its payout ratio, currently 25%, to reach 35% by 2018. Should CVS meet both its payout target and the consensus long-term forecast of 15% for annualized profit growth, the dividend will grow at a yearly rate of 25%. If CVS increases earnings at half the rate analysts project, the dividend should still average 17% annual growth. CVS Health, yielding 1.2%, is a Buy and a Long-Term Buy.
Apparel retailers are coping with a challenging environment, typified by weak store traffic, meager sales growth, and declining gross profit margins industrywide. Against that backdrop, Foot Locker ($58; FL) grew revenue 7% in the October quarter, about twice the industry average, and pushed through price hikes to expand gross profit margins.Â
Foot Locker's dividend also compares favorably to its peers. The retailer has raised its quarterly dividend by 9% to 11% in each of the last four years. Despite surging 39% this year, Foot Locker shares yield 1.5%, exceeding the peer-group average of 1.3%. The payout ratio of 26% also lags the average of 38% for dividend payers in the industry. Foot Locker, which typically announces dividend hikes in February, is a Focus List Buy and a Long-Term Buy.