Buying dividend stocks can be a terrific way to generate passive income. Many companies consistently pay quarterly dividends (and some even pay monthly), allowing you to collect recurring cash flow to cover your living expenses or reinvest into more dividend stocks to grow your passive income. As your passive income grows, you'll become more financially independent.
Those desiring to collect passive dividend income often focus on a stock's dividend yield, because the higher the yield, the more income you can generate from every dollar you invest. However, that's not the most important metric for dividend investors. Instead, the crucial characteristic to consider is whether a company can grow its dividend, because those stocks have historically produced much higher total returns over the long run.
Digging into the data on dividend stocks
Over the past 50 years, the average dividend stock in the S&P 500 (SNPINDEX: ^GSPC)has delivered a 9.2% average annual total return, according to data from Ned Davis Research and Hartford Funds. That has outperformed the average non-dividend payer by more than 2-to-1 (4.3% average annual return by non-dividend payers).
However, digging into the data on returns by dividend policy shows that not all dividend stocks perform at the same level:
Dividend Policy
Returns
Dividend growers and initiators
10.2%
No change in dividend policy
6.8%
Dividend cutters and eliminators
-0.9%
Data source: Ned Davis Research and Hartford Funds.
As that table shows, companies that have initiated dividends or grown their payouts have delivered much higher returns than companies that kept the payouts flat. Meanwhile, companies that cut or eliminated their dividend have lost money for their investors.
Dividend growth in action
Realty Income(NYSE: O) epitomizes dividend growth stocks. The real estate investment trust (REIT) has increased its dividend 130 times since its public market listing in 1994. It has unbroken streaks of 30 straight years and 110 consecutive quarters of increasing its dividend.
Overall, the REIT has grown its dividend at a 4.3% compound annual rate during the past three decades. That dividend growth has helped Realty Income produce a robust total return that has averaged 13.4% annually over the last 30 years.
One thing worth noting about Realty Income is that it has a high dividend yield (5.8%, compared to 1.3% for the S&P 500). However, the REIT's high-yielding payout is very sustainable and should continue growing.
Three factors help contribute to a company's ability to sustain and grow its dividend over the long term:
Resilient and growing cash flow: The company operates in a noncyclical industry or has highly stable cash flows from long-term contracts or similarly stable structures. It also needs to operate in an expanding sector.
A conservative dividend payout ratio: Generally, a company should have a dividend payout ratio of less than 75% of its free cash flow. Lower is better, though a company can have a payout ratio toward the high end if it has very stable cash flow.
A strong balance sheet: A company should have an investment-grade credit rating with low leverage ratios for its sector.
Realty Income checks every single box. It owns a globally diversified portfolio of properties secured by stable net leases. It pays out less than 75% of its adjusted funds from operations. Meanwhile, it's one of only eight REITs in the S&P 500 with two bond ratings of A3/A- or better.
The company's strong financial profile enables it to acquire additional income-generating net lease properties, as it steadily capitalizes on the nearly $14 trillion market for global net lease properties.
Warning signs abounded
Contrast the performance of Realty Income with that of fellow REIT Medical Properties Trust(NYSE: MPW). The healthcare REIT has delivered an abysmal total return of -8.4% annually over the past five years. A big driver of those poor returns has been two deep dividend cuts.
Medical Properties Trust encountered issues when its top two tenants experienced financial problems following the pandemic. They weren't able to consistently pay rent. That wouldn't have been a problem if the REIT had a more diversified portfolio. However, those two tenants contributed more than 35% of its revenue in 2022.
Making matters worse, Medical Properties Trust had a high dividend payout ratio (over 80% at the time) and junk-rated credit. Given its financial troubles, the REIT had to cut its dividend very deeply to retain cash and reduce debt. The combination of falling cash flows, financial problems, and dividend reductions has contributed to its poor returns.
Focus on dividend growth for the best returns
Dividend investors must focus on whether a company can grow its high-yielding payout. If they don't, they could end up earning much lower total returns and see their passive income fall. That could set them back on their pursuit of financial independence through passive income.
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Matt DiLallo has positions in Medical Properties Trust and Realty Income. The Motley Fool has positions in and recommends Realty Income. The Motley Fool has a disclosure policy.
