I like dividends as much as the next guy, but not all dividends are created alike. While high yields are enticing, they may not be sustainable. That's why it is important to look beyond the high yield and find companies with decent returns on equity, indicating they are creating investor value beyond simply paying a dividend.
A short primer
Companies typically pay dividends as growth begins to slow, but there are exceptions to this rule. Some young companies return value to investors by paying dividends in order to attract new investors. Wal-Mart, for example, went public in 1972 and started paying a dividend just 18 months later.
The dividend payout ratio is an important figure to look at in determining whether a dividend is sustainable. A company that pays more than 100% of its income as dividends may not be able to sustain those payments, whereas companies with a smaller payout ratio leave themselves some income to reinvest in the company. Bear in mind, though, that certain types of stocks have to pay out a large portion of income as dividends.
Return on equity (ROE) is an indicator of how profitable a company is for its shareholders. Expressed as a percentage, it measures the amount of equity earned per dollar invested in the company by shareholders. Taken in conjunction with the payout ratio, we can calculate to see whether a company has sustainable growth. This number may be small for some companies, but in times such as these, minimal growth is better than no growth.
What I am looking for
In my analysis today, I looked for profitable companies that pay dividends over 5%, pay out less than 100% of earnings as dividends, and have an ROE over 20%. I narrowed the list to five companies that meet all these criteria and have a sustainable growth rate over 5%. I feel that they would be a welcome addition to any portfolio. Although the companies are in various industries, they compare favorably with one another.
Return on Equity
Sustainable Growth Rate
Altria Group (NYS: MO)
AstraZeneca (NYS: AZN)
Eli Lilly (NYS: LLY)
National Grid (NYS: NGG)
Southern Copper (NYS: SCCO)
Source: FinViz.com, as of Sept. 27.
Altria Group is the parent company of domestic cigarette giant Philip Morris USA. Because Altria can expect Americans to continue buying its products, it needs to retain less of its income to grow the company further. Reynolds American, Altria's primary U.S. competitor, also has a payout ratio near 90%, though its ROE is a third of Altria's, bringing its sustainable growth rate below 3%.
Leading pharmaceuticals companies AstraZeneca and Eli Lilly are developing drugs to treat a wide assortment of major diseases. All drug companies face a challenge when patent protection on their drugs ends. When a drug "goes generic," pharmaceutical companies can experience a hit to their annual revenues. They need to continually reinvest earnings back into the development pipeline, where it can take 12-15 years to bring new drugs to market.
Unfortunately, the patents on AstraZeneca's two best-selling drugs, Crestor and Nexium, expire in 2016 and 2014, respectively. Eli Lilly, on the other hand, loses patent protection on its best-selling Zyprexa next month, but has nine drugs in late-stage trials. Bristol-Myers Squibb (NYS: BMY) compares favorably to both companies, but fails a key component of my test due to its dividend yield around 4%.
National Grid is a utility company based in the U.K. It is holding onto more than 50% of its net income to fund future growth, and management has promised 8% dividend growth for the next two years. In order to find comparable utilities, I had to lower my targets a bit, but Exelon is a strong option yielding just under 5%, but with an ROE of less than 20%.
Southern Copper is part of a cyclical industry and performs best when economies are strong. That being said, the best times may be ahead for this leading copper producer, which hopes to sell copper to China by 2013. The world's largest publicly owned copper producer, Freeport-McMoRan (NYS: FCX) , actually shows a higher sustainable growth rate, but it was eliminated from my screening because of its lower yield.
Any other options?
These are just five of the many promising companies that pay dividends. Click here to find a few more choices in our special free report "13 High-Yielding Stocks to Buy Today."
At the time thisarticle was published Foolish contributor Robert Eberhard does not own shares in any company mentioned here. Follow him on Twitter @GuruEbby. The Motley Fool owns shares of Wal-Mart and Altria. Motley Fool newsletter services have recommended buying shares of Exelon, Wal-Mart, and National Grid, as well as writing a covered strangle position on Exelon and creating a diagonal call position on Wal-Mart. 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.
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