Don't Overpay for Dividend Darlings

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The concept of investing in so-called "dividend stocks" is an appealing one. Not only is there the prospect of share appreciation but also a consistent, ever-growing stream of income. But it's important to avoid overpaying for these types of stocks, sometimes difficult because many trade at fairly high valuations.

There are three important things to look for in a dividend stock. The first is the dividend yield, the second is the dividend growth, and the third is the history if dividend increases. I've found three companies with yields around 4%, well above the S&P 500 average, but with poor prospects of dividend growth, which are nonetheless popular among dividend investors. Many people look at yield and very little else, but two of these three companies are examples of why that strategy can run afoul.

Consolidated Edison (NYSE: ED)

Consolidated Edison is a utility company based in New York that provides electric service to 3.3 million customers and gas service to 1.1 million customers. Many people buy utility stocks because they consider them safe, reliable companies with steadily increasing dividends. Con Ed has increased its dividend each year for the past 38 years, and the stock currently yields about 4.25%.

While the yield is well above average the dividend growth has been anemic. The annual dividend has grown a total of 8% since 2003, or just 0.86% on an annualized basis. Is 38 years of growth meaningful if that growth is this slow? During this time annual revenue has increased by 24% and net income has more than doubled. The payout ratio has fallen from almost 95% to 63% during this time, so it's possible that dividend growth over the next decade will be a bit faster since the payout ratio has become more sustainable.

How fast does the dividend need to grow annually in order to justify the current market price of Consolidated Edison?

<img src="/media/images/user_13886/ed-top_large.png" />

<img src="/media/images/user_13886/ed-bottom_large.png" />

While 3.67% annual dividend growth is not particularly fast, it is about 4 times faster than Con Ed has increased its dividend over the last decade. The stock price is propped up due to the belief that the stock is safe, and indeed if you prefer consistent, mediocre returns then Con Ed is perfectly fine. But dividend growth is almost non-existent, meaning that you're effectively buying a 4% bond. Not too alluring.

Merck (NYSE: MRK)

Merck is a large pharmaceutical company with about $47 billion in annual sales. Merck currently yields 4%, and in 2011 raised its dividend for the first time since 2005. This is a great example of a company that looks like a good dividend stock on the surface but turns out to be rather poor. Merck has increased its dividend at an annualized rate of 1.64% since 2003, almost double that of Con Ed above but still woefully slow. What's worse, the payout ratio has actually risen during that time, from around 50% to 75%. This bodes poorly for future dividend growth.

How fast does Merck need to grow its dividend to justify the current market price?

<img src="/media/images/user_13886/mrk-top_large.png" />

<img src="/media/images/user_13886/mrk-bottom_large.png" />

Much like Con Ed, Merck need to grow its dividend at well above the historical rate, 3.87% compared to just 1.64%. Although Merck certainly looks a lot better than Consolidated Edison, it's still a poor dividend stock.

Southern Company (NYSE: SO)

Southern Company is another utility company. The stock yields 4.38%, similar to the yield of Con Ed. However, Southern Company is far and away a better dividend stock than Consolidated Edison. Southern has grown its dividend at an annualized rate of 3.77%, more than four times the rate of Consolidated Edison. The payout ratio has grown slightly during that time but currently sits around 73%, not outrageous for a utility.

How fast must Southern Company grow its dividend to justify its market price?

<img src="/media/images/user_13886/so-top_large.png" />

<img src="/media/images/user_13886/so-bottom_large.png" />

The necessary annual growth of 3.5% is slightly less than the historical rate of 3.77%, making Southern Company a good stock to own in a dividend focused portfolio. On the surface Southern Company and Consolidated Edison look very similar, but they are very different as investments. Con Ed is vastly overvalued given its anemic dividend growth rate while Southern has been growing its dividend at a steady rate which is fast enough to justify its price.

The Bottom Line

All dividend stocks are not created equal. Even though all of these three stocks have yields around 4% only one of them, Southern Company, is a reasonable investment. Both Consolidated Edison and Merck have grown their dividends far too slowly to justify their current market prices. They should both be avoided.

TheBargainBin has no position in any stocks mentioned. The Motley Fool recommends Southern Company. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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