It's easy to fall in love with a stock that sports a generous dividend yield, but savvy investors know that steady dividend growth is even more enticing than yield. Dividend growth allows investors to harness the power of compounding, which can transform today's modest dividend payer into a superstar yielder as dividends rise year after year. If fact, this is exactly the kind of strategy Amy Calistri uses in her Daily Paycheck newsletter.
The table below illustrates the power of compounding using the Coca-Cola Co. (NYSE: KO) as an example. In the past decade, Coca-Cola has increased its dividend roughly 10% a year. Today, the stock yields about 2.5%, but if dividends continue to grow by 10%, yield (on the original investment) climbs to 4.0% by year five and exceeds 5% by year seven -- nearly double the initial yield.
My example assumes 100 shares purchased today for $78, a total initial investment of $7,800...
I identified other attractive dividend growth stocks by running a screen for companies that have at least seven consecutive years of 10% or higher dividend growth and payout ratios of 50% or less.
A conservative payout ratio is desirable, because it gives companies flexibility and the ability to raise dividends through good times and bad. Each of the three stocks below is a standout based on consistent high-dividend growth, safety and above-average yield.
1. Walgreen Co. (NYSE: WAG)
Yield: 4%
Walgreen is the United States' leading drug store chain, with about 8,000 stores in the United States and Puerto Rico. Last year, it filled a record 819 million prescriptions -- that's one in every five retail prescriptions in the country.
Walgreen's earnings per share (EPS) dropped 2% in the first nine months of fiscal 2012 ended May 31 to $2.03 from a year earlier, mainly due to the company's ongoing contract dispute with Express scripts (Nasdaq: ESRX), which caused the number of prescriptions filled to fall.
But Walgreen just announced a major acquisition that should re-energize growth. The company plans to acquire a stake in Alliance Boot, Europe's leading pharmacy chain, for $6.7 billion. Together, the two companies will form the world's largest drug store chain, with 11,000 retail stores in 12 countries. Walgreen expects the merger to be immediately accretive and add as much as $0.27 to fiscal year 2013 earnings per share.
Walgreen has raised dividends 37 years in a row and by a 19% annual rate in the past 10 years. In June, the company hiked its dividend 22.5% to a $1.10 annual rate yielding almost 4%. Walgreen plans to maintain payout at less than 40%.
2. Endesa Chile (NYSE: EOC)
Forward yield: 4%
Endesa Chile owns 29 power plants and distributes electricity in Colombia, Argentina, Peru and Brazil. This company accounts for 37% of the total generation capacity of Chile and is the largest player in the local market.
The company plans to invest $2.75 billion in regional expansion during the next five years, including $800 million in 2012. Demand for electricity is forecast to rise sharply in Chile, so this company should benefit from its monopoly position in this fast-growing South American market.
La Nina related-drought conditions negatively affected the company's hydroelectric operations and resulted in a 32% drop in first-quarter 2012 earnings to $135.2 million from one year earlier. A return to more normalized weather conditions is predicted, which could help earnings. The company generates more than enough cash flow ($1.44 billion in the past 12 months) to cover the $562 million dividend payment.
In the past decade, this "steady eddie" has produced 13% annual growth in earnings and 16% a year dividend growth. At present, Endesa pays a $2.04 annual dividend that yields 4%. Analysts predict at least 12% earnings growth next year.
3. Darden Restaurants (NYSE: DRI)
Yield: 4%
Darden Restaurants is the world's largest company-owned, full-service restaurant business. Its chains include Olive Garden, Red Lobster, Longhorn Steakhouse, Capital Grille, Bahama Breeze and Seasons 52.
Darden is benefiting from falling gas prices, which attracts more Americans to eat out. In addition, the company's new Red Lobster-Olive Garden combo restaurants are being used to expand in smaller markets that were not previously viable.
The company's earnings have grown 7% a year for the past five years, and analysts predict growth could accelerate to 12% in each of the next five years. The stock is also attractively valued. Darden has a price-to-earnings ratio (P/E) of 11 based on next year's earnings, which is roughly half the industry P/E of 21.
Darden has a 17-year dividend track record and has raised payments by 30% a year on average in the past five years. The payout is also conservative at 48% of earnings. Last month, the company raised the dividend 16% to a $2.00 annual rate, giving the stock a yield of nearly 4%.
Risks to Consider: Walgreen is making the largest acquisition in its history and needs a smooth integration of the two businesses to realize earnings benefits. Endesa Chile pays dividends in pesos, which creates currency risk for U.S. investors. In addition, Chile has a high 35% withholding tax rate on dividends.
> My top pick overall is Walgreen. This company has a stellar record for dividend growth and opportunities to boost profits through a major acquisition. Darden Restaurants is attractive as a value play, while Endesa Chili should appeal to investors who like high dividends and exposure to Latin American growth.
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