Many income investors focus mainly on yield when they should be giving at least equal weight to dividend growth, as well as prospects for future gains. Why is dividend growth so important? The answer is simple: Even modest yearly increases in the dividend add up to a sizable income  over time for long-term holders. Consider the following example:

You purchase a stock paying a $0.12 dividend. The following year, the company increases the dividend to $0.16 — a 25% boost. A year later, the dividend is hiked again, this time to $0.20. The company reports a 25% dividend increase (a $0.04 increase divided by $0.16). From the perspective of the original holder, however, the actual income gain is 33% ($0.04 divided by $0.12).

The company calculates the increase based on the last rate, but individual holders should figure the increase based on the original rate when shares were purchased. This also applies when you consider the yield, too. It’s easy to pay attention to what a stock is currently yielding, but for the investor who got in before a stock price goes up (and received those nice dividend boosts), it’s the “effective yield” on the original purchase price that really matters.

Returns become even more compelling when dividends are reinvested, because this leverages the power of compounding. [See “How to Earn 26.5% on $20,000”] Investors essentially acquire free stock by re-investing dividend income in more shares and then turbo-charge the process by choosing stocks that consistently grow dividends.

In selecting dividend growth stocks, I consider a number of factors:

First, I begin with companies that have a track record of dividend increases, since these are more likely to continue increases in the future. I also look at the earnings track record, since dividend growth is sustainable only if accompanied by steady earnings gains. A third factor I consider is dividend payout. Companies with high payouts — say 60% or higher, have less ability to increase dividends if earnings fall, even if the decline is temporary. I compare the current payout to historic levels, since a rising payout may mean smaller dividend increases in the future. The final factor I examine is the balance sheet, because companies with sizable debt loads often have loan covenants that restrict dividend growth. 
   
Here are five stocks growth/yield hybrids that have also doubled dividends in the past five years:

1. McDonald’s Corp. (NYSE: MCD)
Yield: 3.2%

America’s largest restaurant franchise has grown dividend payments 27.5% on average in each of the past five years. Earnings per share (EPS) have risen 18%. Dividend growth above 25% means that McDonald’s in effect doubles its dividend payments every four years. The company is considered a “dividend aristocrat,” which means it has recorded at least 25 consecutive years of dividend growth. McDonald’s current payout from earnings is 49%, which leaves a comfortable cushion for dividend growth even if short-term fluctuations in earnings occur.

2. Medtronic, Inc. (NYSE: MDT)
Yield: 2.4%

This maker of medical devices has impressed by boosting dividends 19.6% on average each of the past five years. EPS growth has been favorable as well, although slightly slower, at 13.6% a year. Medtronic has increased its dividend every year for 33 consecutive years. Payout is modest at 30% of earnings and leaves ample room for more growth.

3. Illinois Tool Works (NYSE: ITW)
Yield: 2.5%

Annual dividend payments for this industrial equipment manufacturer have increased 19% each of the past five years. In the last 25 years, the company has managed to double its dividend every five years. Payout is typically below 39%. This allows flexibility for future dividend growth.

A caveat regarding Illinois Tool Works is that EPS growth has been mildly negative in recent years at 2.5%. However, the company is rebounding from the recession. Consensus analyst estimates look for 20% EPS growth next year and annual growth averaging 16% in the next five years.

4. Automatic Data Processing (Nasdaq: ADP)
Yield: 2.9%

Payroll processing services provider ADP has grown annual dividends at a 17.4% rate in the past five years. This translates into more than doubling its dividend every five years. During the same period, EPS growth has been positive but slightly slower at 12.6%. The track record during the past 25 years shows a consistent pattern of ADP doubling its dividend every five years. At present, the company’s dividend payout from earnings is a bit high at 56%, but ADP generates strong cash flow (payout as a percentage of cash flow is a reasonable 43%).

5. Wal-Mart Stores (NYSE: WMT)
Yield: 2.1%

America’s leading discount retailer is also a leader in dividend growth. The company has produced 16% annual growth in dividends during the past five years and effectively doubled the dividend. In addition, Wal-Mart has a track record indicating 36 consecutive years of dividend growth and annual growth over 10 years exceeding 18%. EPS growth has been reliable, averaging 8.6%. Payout is modest at 29% and provides a nice cushion for future dividend increases. 

Action to take–> Aggressive investors should like Illinois Tool Works for its sizable dividend gains and improving growth prospects. More conservative investors may prefer steadier, less cyclical performers such as McDonald’s and Wal-Mart.