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Dividend Investors Won't Want to Overlook This Beaten-Down Growth Stock

Motley Fool - Thu Jan 4, 4:43AM CST

Many dividend investors focus too much on a stock's current dividend yield. That can shortchange their returns.

That's clear from the total returns generated by dividend stocks over the last half-century. While dividend payers have produced a 9.2% average annual return, according to data from Ned Davis Research and Hartford Funds, there's a huge disparity. Dividend growers and initiators have produced a 10.2% average annual total return, while companies with no change in their dividend policy have only delivered a 6.6% average annual total return.

That strong returns data for dividend initiators and growers is why dividend-focused investors shouldn't overlook Paycom Software(NYSE: PAYC). While the cloud-based payroll company currently offers a seemingly paltry payout (it yields 0.7%, about 50% less than the S&P 500 index), it just initiated that dividend last year. Further, it should have no problem growing its payout in the future. That puts it in an excellent position to produce attractive total returns.

Starting small

Paycom unveiled its cash dividend policy last May. It set its inaugural dividend payment at $0.375 per share each quarter ($1.50 annually). The initiation of a dividend marked the next step in the company's strategy to return value to shareholders (it has also spent around $700 million to buy back about 5 million shares over the years).

That dividend payment is a small portion of its cash flow. It costs the company about $22 million per quarter. That puts its dividend payout ratio at less than 20% of its operating cash flow and around 25% of its earnings. This low rate enables the company to retain a lot of cash to fund growth, repurchase shares, and maintain a cash-rich balance sheet. With $484 million cash and only $29 million debt, Paycom's cash balance alone could fund its dividend payment for several quarters if its cash flow dried up.

Room for growth

Paycom left itself with plenty of room to grow its dividend. For starters, its payout ratio is well below that of its peers in the industry. Payroll leader ADP(NASDAQ: ADP) targets a payout ratio between 55% and 60% of its earnings. Meanwhile, Paychex(NASDAQ: PAYX) has paid out around 75% of its free cash flow in dividends over its last two fiscal years.

However, Paycom can grow its dividend without increasing its payout ratio. Its earnings and cash flow are growing briskly, which should support a rising dividend. Its revenue jumped more than 25% through the first nine months of 2023, while its earnings per share surged almost 29%. Meanwhile, its operating cash flow rocketed nearly 50% through the first nine months of 2023 compared to the same period in 2022.

On the one hand, Paycom won't grow quite as fast in the near term. The company's cutting-edge payroll software, Beti, is proving to be too good at eliminating payroll errors. That's causing lower-than-expected service revenues and unscheduled payroll runs, which has weighed on revenue growth. This headwind should remain in force over the next year. That drives Paycom's belief that its sales growth will slow to 10%-12% in 2024. However, that's still a solid growth rate (ADP and Paychex expect their revenue to rise 6% to 7% during their 2024 fiscal years).

While Paycom sees growth slowing in the near term, it could reaccelerate in the future. The company continues to invest heavily in innovation, sales, and marketing. Those investments should help drive growing cross-sales with existing clients and help it win new customers. Paycom believes it has a long growth runway to capture a large and growing market for providing payroll and other HR solutions. The company's growing earnings and cash flow should enable it to steadily increase its dividend in the coming years. That has been the case for rivals ADP and Paychex. APD delivered its 49th year of dividend growth in 2023 (increasing its payment by 12%), while Paychex has steadily increased its payout over the years, including by 13% last year.

The potential to become a dividend growth machine

Paycom joined the ranks of dividend payers last year. While the company started small, it has the financial strength and growth prospects to increase its payout at a high rate in the coming years. That bodes well for its investors, considering that dividend growth stocks have historically been strong performers. That outperformance is even more likely considering that the stock took a beating last year and now sits nearly 45% below its 52-week high. That prospect of earning market-beating total returns powered by a growing dividend is why dividend investors shouldn't overlook Paycom's rather small payout.

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Matthew DiLallo has positions in Paycom Software. The Motley Fool has positions in and recommends Paycom Software. The Motley Fool has a disclosure policy.

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