Investors who like dividends, especially beginning investors, can happen upon many an enormous yield and end up paying the price. Last week, I showed how Windstream (NAS: WIN) -- a company that currently offers a 9.9% dividend -- isn't exactly a sure bet for continued high payouts.
Today, I'm looking at the other end of the spectrum: quality companies with dividends that might seem puny but actually have lots of room for growth. Read ahead to find out what the three companies are, and at the end, I'll offer up access to a special free report on three Dow stocks that every dividend investor needs.
But first, here's what I went looking for
Before getting to the three companies, I think it's important to know how I came to my conclusion. First of all, I only went looking for quality companies that have shown leadership in their fields and have a track record that leads me to believe they'll be around for the foreseeable future.
Second, the company needs to offer a dividend with a low payout ratio. In the most basic sense, this means that the company uses no more than 50% of its earnings to pay its dividend.
But there's a catch here that makes the earnings payout ratio a little unreliable. Because things like depreciation and amortization are used to help calculate earnings, it's not really a true measure of how much cash is coming in and going out. To get a better reading, I also look at how much free cash flow is being used to pay out dividends.
In either case, it's important to have a ratio below 50% for two reasons. First, if a business hits a rough patch, it means that it has enough of a cushion to weather the storm and continue paying its dividend. Second, if business does continue doing well, then there's a lot of room for safe growth of the payout.
Knowing these things, here are my three candidates, with their industry and payout ratios included.
Earnings Payout Ratio
Free Cash Flow Payout Ratio
Coach (NYS: COH)
ExxonMobil (NYS: XOM)
Oil and gas
Cummins (NYS: CMI)
At first blush, this might seem like just the type of stock risk-averse dividend investors should avoid: a company whose financial future is based on the whims of fashion. But this is no ordinary fashion company.
Over the past three years, Coach has grown earnings per share by 23% per year. This is due in no small part to the leadership of CEO Lew Frankfort. The man is so passionate about finding out what his customers want -- and then giving it to them -- that after hearing his message a number of years ago, Fool CEO Tom Gardner decided it was time to start asking Foolish customers what they wanted. Million Dollar Portfolio is a direct result of Tom's visit with Frankfort.
Coach weathered the economic downturn, and though it still faces challenges abroad, could easily turn itself into a dividend stalwart. Only one-quarter of free cash flow is being used to pay dividends, meaning there's lots of safety in the payout right now.
Most investors are very familiar with the world's second-largest company, in terms of market cap. What you might not know, however, is that in addition to being a leader in providing petroleum-based fuel for the world, Exxon is also the country's largest natural gas producer, and is making in-roads into periphery industries.
Though the price of gas can play a major role in how much cash the company brings in, Exxon has set itself up as a reliable dividend payer. In fact, if you bought and held the stock from the start of 2000 until today, you would have earned a 131% return. But throw in dividends reinvested, and you're looking at a 210% return.
There's no guarantee that this will happen in the future, but with a nice dividend, a low payout ratio, and a spot on top of the energy world, there's a lot to like here.
Lastly, we have Cummins, a company that manufactures engines for long-haul truckers. The company is already at the cutting edge of providing machinery that meets or exceeds emission standards. As the world becomes more eco-conscious, this could be a huge benefit.Cummins, through its partnership with Westport Innovations (NAS: WPRT) , is also a leader in providing engines that can run solely on natural gas.
With only 35% of free cash flow being used to pay out dividends, and a stock that's already seen a third of its value disappear since mid-March, there's a chance for solid dividends and price appreciation with Cummins.
More solid dividends
If you're looking for some long-term investing ideas, let me invite you to read the Fool's brand-new special report: "The 3 Dow Stocks Dividend Investors Need." It's absolutely free, and will reveal three more companies that share same characteristics as the ones above; so just click here and get your copy today.
The article 3 Dividends With Lots of Room for Growth originally appeared on Fool.com.
Fool contributor Brian Stoffel owns shares of Westport Innovations. The Motley Fool owns shares of Cummins, Coach, Westport Innovations, and ExxonMobil. Motley Fool newsletter services recommend Coach, Cummins, and Westport Innovations. 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.