Chasing yield has become a challenging mission for investors in recent years. As yields collapsed in fixed income, investors flocked to bondlike substitutes, such as high-dividend-yielding stocks. Now that these stocks have become a bit pricey, we think companies with strong dividend growth potential offer a better way to source equity income.

There are many ways to look at dividends. A good starting point is the payout ratio, which measures the proportion of net income that a company pays out to shareholders. At the end of 2013, U.S. companies were paying out only one third of their earnings as dividends, well below the average of the past 60 years (see chart 1). 

 

Payout ratios matter. When they are low, the ratios show that many companies have lots of room to raise dividends. And since U.S. companies have record cash positions and solid balance sheets, we think it’s easy to envision how payouts can increase.

This ratio also helps explain why dividends have been growing faster than profits. For U.S. nonfinancial companies, earnings growth remained sluggish in 2013. Yet because payout ratios were so low, dividend growth outpaced earnings growth by a wide margin (see chart 2). And since companies with strong dividend growth typically have not been on investors’ radar screens, they’re trading at especially cheap valuations when compared with high-dividend-yield stocks.

There are examples of this in many sectors. In aviation, Chicago-headquartered Boeing Co. increased its annualized dividend by 50 percent at its board meeting in December. Minnetonka, Minnesota–based health insurance company UnitedHealth Group raised its dividend by 32 percent in 2013. Woonsocket, Rhode Island–headquartered consumer staples retailer CVS Caremark lifted its dividend by 30 percent last year. And even in financials, San Francisco–headquartered financial services company Wells Fargo & Co. boosted its dividend by 31 percent. What do all of these companies have in common? Low-dividend-payout ratios.

So how can we identify companies with strong dividend growth potential? It all starts with the payout ratio. When a company has a high payout ratio, it often means management does not see compelling opportunities to invest in growing the business. We believe that companies with lower payout ratios have more control over their destiny than do peers with weaker cash dynamics, which gives them capital flexibility to invest in projects for future growth or to return excess capital to shareholders by increasing dividends or share buybacks.

But even companies with low payout ratios need to be scrutinized. It’s especially important to look beyond reported earnings, which can be misleading. By focusing on the cash economics of a business, investors can get a better grip on a company’s capital needs and commitment to investing in growth opportunities.

For example, a close look at the balance sheet can reveal a company’s capacity to finance expansion and provide a means to evaluate the percentage of normal cash flow being paid out as dividends. The goal is to identify healthy companies capable of withstanding both macroeconomic shocks and competitive threats.

Finding income is still high on the agenda of many investors. Yet traditional sources of yield in fixed-income and equity markets have simply become overpriced, in our view. It’s definitely possible to find stocks with higher dividend yields. But we believe that companies with low payout ratios and high dividend growth potential can provide investors with a better way to quench their thirst for income over the long term.

Frank Caruso is the team leader of U.S. growth equities at AllianceBernstein in New York.

See AllianceBernstein’s disclaimer.

Get more on equities.