How Much Further Can Dividends Rise?

Investors are hungrier than ever for dividend stocks, and the feeding frenzy shows no sign of slowing down. Rather, as the stock market soars toward all-time highs, the more important question is whether dividend increases can keep up the pace.

So far, the answer seems to be yes. After huge dividend increases in 2012, dividend-paying stocks are off to a good start in the new year. Moreover, all signs point to companies having plenty of capacity to raise their payouts in the future -- as long as they actually want to pay more.

Forget the fiscal cliff
In 2012, the market set all sorts of new dividend records. According to data from S&P Dow Jones Indices, companies paid $281.5 billion in dividends during 2012, up 17% from the previous year and handily beating the previous record of around $248 billion set back in 2009. Nearly 2,900 companies raised their payouts last year, which was also a record high since the company started tracking dividend increases.

Some skeptics might argue that the rise in dividend payments came largely because of concerns over the fiscal cliff and the rush among companies to accelerate dividends into the 2012 tax year to take advantage of favorable rates. As it turned out, the worst-case scenario didn't play out for dividend taxation, as the compromise that lawmakers reached set a maximum tax rate of 20% on dividend income, well below the top 39.6% rate that would have applied under previous law.

Yet even with the higher rate, companies haven't hesitated to boost their payouts. Consider these recent examples:

• Just yesterday, 3M (NYSE: MMM  ) raised its payout by 8%, extending its streak of rising dividend payouts to 55 years. With the rise, 3M shares now yield 2.5% despite trading at all-time highs.
• Last week, fertilizer company PotashCorp (NYSE: POT  ) pushed its dividend higher by a more substantial 33%, raising its yield to 2.6% and marking the fourth increase in its payout in two years. With healthy conditions in the fertilizer market and a just-concluded deal to export more potash to China, PotashCorp was in a good position to reward shareholders.
• Wells Fargo (NYSE: WFC  ) hiked its dividend last month by 14%, making its annual payout an even $1 per share and pushing its yield closer to the 3% mark. Wells Fargo is just one of many banks that have gradually raised their dividend payouts as they've recovered from the financial crisis.

Payout increases are good news for investors, but how long can the good times last? Despite worries, many dividend experts are bullish about the prospects for future payout growth.

What a company can pay
In the end, a company's ability to pay dividends depends on its being able to obtain cash to make those payments. Although some companies finance their dividends through debt or by making secondary offerings of stock, ideally, you want companies that can earn the money they pay in dividends.

Corporate earnings have moved to extremely high levels lately, as profit margins have improved substantially. With wage pressures minimal due to high unemployment, more of the growth that companies produce has fallen to their bottom lines, benefiting shareholders.

The result of those trends is that even with massive dividend increases, companies are paying out less of their earnings than usual. S&P Dow Jones Indices pegs the overall payout ratio at about 36%, well below long-term average levels of 52%. For 3M, Wells, and PotashCorp, all three are paying less than half their earnings out as dividends.

Put another way, if companies wanted to match the amount they traditionally return to shareholders, they would have to do an instant dividend increase of nearly 45%. That surge would push total dividend payments above the $400 billion mark and lead to a lot more income for stock investors.

Watch for dividends
Overall, the trend toward higher payouts bodes well for dividend investors. For those who prefer diversified exposure, dividend ETFs SPDR S&P Dividend (NYSEMKT: SDY  ) and Vanguard High Dividend Yield (NYSEMKT: VYM  ) should continue to reward their shareholders with rising income. As long as corporate profits stay healthy, the fundamentals behind rising dividend payouts will remain intact.

Great companies make great dividend stocks, and Wells Fargo has done a good job outperforming its peers since the financial meltdown. But is the bank stock still a smart investment? To help figure out whether Wells Fargo is a buy today, I invite you to download our premium research report from one of The Motley Fool's top banking analysts. Click here now for instant access to this in-depth take on Wells Fargo.