(12/29/14) Payout Ratio Picks

Income investors should consider companies’ capacity for future dividend 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, explains Richard Moroney, editor Dow Theory Forecasts.

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 without sacrificing the dividend or cutting back in other strategic areas, such as stock buybacks, capital investments, and acquisitions.

Based on payout ratios, here are four of our favorite dividend stocks:

Aetna (AET)

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.

Aetna recently 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 yields 1.1%.

Ameriprise Financial (AMP)

Ameriprise is an asset manager; an industry that requires little capital investment. In the first nine months of 2014, it returned $1.4 billion to shareholders through dividends and stock repurchases. During that period, the quarterly dividend rose 12% and the share count fell 4%.

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 currently yields 1.7%.

CVS Health (CVS)

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 consensus forecasts 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 yields 1.2%.

Foot Locker (FL)

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 grew revenue 7% in the October quarter, about twice the industry average.

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.