Monday, December 3, 2018

3 Exceptional Dividend Growth Stocks With Quality Financials

Any master architect will tell you the key to a quality structure is its foundation. Solid buildings have firm foundations. The more solid the foundation, the less likely the building will suffer damage from storms, earthquakes, or settling of the earth. In much the same way, the foundation of solid Dividend Growth Stocks are their financials. Here's what to look for when evaluating a dividend stock's financials...

Growing Equity

Changes in shareholder’s equity are a result of earnings, dividends paid, treasury stock purchased, stock options exercised and stock issued. If shares outstanding aren’t increasing, and equity is rising then the business is generating sufficient earnings to cover dividends and share repurchases. Increasing the value of the company by running the business well is a sign of a healthy company.

Declining Shares

Many companies sell stock to raise cash. The important question is what is the company going to do with the cash? Is it for an acquisition or “general corporate purposes?” The latter is code for the business is not generating enough cash to stay afloat on its own. I am leery of a company that consistently grows its shares outstanding in the absence of major acquisitions.

Free Cash Flow

Free cash flow focuses on cash generated by the business. It excludes asset sales and cash generated from financing, such as debt issuances and stock sales. To have cash available for dividends, a company must have cash left over after paying the operating expenses and normal capital expenditures. For this I looked for companies that had positive free cash flow for the last 10 years and a free cash flow payout less than 60%.

Debt To Total Capital

Dividends that are paid out of free cash flow must compete for other needs of the business such as interest and debt payments. Lower debt and interest requirements make available more cash for dividend payments. Like shares outstanding, I am leery of a company that consistently issues debt in the absence of major acquisitions. For this metric, I looked for companies that have a debt to total capital of 45% or less.

Cash On The Balance Sheet

Some businesses are so good at what they do and have so few opportunities for reinvestment, they tend to build large cash balances. Companies such as this that also pay a cash dividend, provide an additional layer of comfort that the dividend is sustainable.

Stocks With Quality Financials

Amounts in millions

AFLAC Incorporated (AFL) | Yield: 2.3%
Equity: 2008 $6,639, 2013 14,620, 2018 23,800
Shares: 2008 958, 2013 935, 2018 787
FCF Payout: 14%
Debt to Total Capital: 29%
Cash on Balance Sheet: $3,848

Microsoft Corporation (MSFT) | Yield: 1.7%
Equity: 2009 $39,559, 2014 89,784, 2019 82,718
Shares: 2009 8,996, 2014 8,399, 2019 7,794
FCF Payout: 41%
Debt to Total Capital: 51%
Cash on Balance Sheet: $11,946

Hormel Foods Corp. (HRL) | Yield: 1.8%
Equity: 2008 $2,008, 2013 3,311, 2018 4,935
Shares: 2008 549, 2013 540, 2018 541
FCF Payout: 46%
Debt to Total Capital: 5%
Cash on Balance Sheet: $444.1

A solid foundation is just the beginning. Selecting quality dividend stocks with sustainable dividends requires the investor to not only look back at the financials, but also look forward to determine in the business can continue to thrive going forward. To succeed as a dividend investor, you must find companies that can sustain and grow dividends by focusing on their ability to generate cash. You can fake earnings, but you can’t fake cash.

Full Disclosure: AFL, MSFT, HRL.

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