Forget High-Yield Traps: Coca-Cola Is the Best Dividend Stock

Income investors obviously love high dividend yields. After all, the bigger the yield, the greater the cash flow from that particular position.

After nearly three decades in the investment business, however, I know all too well that bigger dividend yields are only part of an income stock's story. If the underlying dividend payment doesn't grow or if the stock in question is likely to lose value rather than gain ground, the solution to your income problem is offset by the creation of another. I've heard such tickers sometimes called yield traps -- stocks that seem attractive due to their sizable dividend yield (frequently resulting from a steep sell-off) but often end up underperforming in other ways, leaving their owners unsure of what to do once they're in a position.

As unappealing as the idea may be on the surface, I'm firmly convinced that sometimes the smartest long-term decision an income-minded investor can make is stepping into a dividend name with a modest entry yield, but a track record of strong net growth -- by all measures -- that will make this investment worth its seemingly slow start. And one of the best of these choices right now is beverage behemoth Coca-Cola (NYSE: KO).

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Coca-Cola under the microscope

You know the company. In addition to its incredibly popular namesake cola, Coca-Cola is the parent to Minute Maid juices, Gold Peak tea, Powerade sports drink, Dasani water, and more. It's got something for every consumer taste.

Just as important, the company knows how to market these products. Credit its sheer size. Not only can The Coca-Cola Company afford to spend more on marketing than its competitors, but grocers know its brands draw shoppers to their stores.

Coca-Cola isn't quite the company it seems to be on the surface, however. Unlike its top rival, PepsiCo (NASDAQ: PEP), Coca-Cola does very little of its own actual bottling these days. It's punted the vast majority of this work -- and distribution -- to third-party bottlers so it can focus on what it does best. That's marketing. This business model also puts the bulk of the ever-volatile production cost burden on these bottlers, allowing the parent to enjoy wider net profit margins even if it generates less revenue.

This model is, of course, ideal for supporting dividend payments. The company's dividend pedigree says as much. Not only has Coca-Cola been able to pay a quarterly dividend like clockwork for decades now, but it has also raised its per-share payout in each of the past 64 years.

Still, Coke's forward-looking dividend yield of 2.4% just isn't thrilling compared to several other options, including the aforementioned PepsiCo, which currently boasts a forward-looking dividend yield of 4.2%.

So why would Coca-Cola be a better choice for income investors?

Think bigger picture, and longer term

Yield matters to be sure. It's not all that matters, though. For anyone planning on sticking with a dividend stock for the long term, reliable and meaningful dividend growth is just as important, if not more important.

And that's where Coca-Cola really shines. Not that PepsiCo's historical dividend growth has been weak, but over the course of the past 30 years, Coke's quarterly per-share payment has grown (on a split-adjusted basis) at an average annual rate of 7.4%, and at an inflation-beating pace of more than 4% for the past turbulent decade. Not bad.

Then there's the other thing. Even if it's not your primary goal right now, Coca-Cola's stock is still capable of producing solid capital growth. A $10,000 investment made 30 years ago would be worth more than $35,000 today, and that's not counting any dividends paid in the meantime. Had you been reinvesting its dividend payments since then, a $10,000 stake purchased back in the middle of 1996 would be worth more than $75,000 today. Moreover, with a forward-looking yield of 2.4%, that stake would be capable of producing a little over $1,800 worth of dividends per year, and the stock itself would still be logging slow and steady gains.

That's why I think Coca-Cola shines through as one of the market's very best dividend prospects even if its yield isn't exactly sky-high right now -- or ever.

If you can be patient enough to see the bigger, longer-term picture, when the time comes, a growth position fueled by persistent dividend reinvestment can become an income holding in the future simply by stopping your dividend reinvestment and instead starting to collect those payments in cash. In this particular scenario, your effective dividend yield on your initial investment is far higher than what it would be if you were just now opening a position in KO.

Perhaps my more important point is that there's more to picking the right income investment than a simple snapshot of a stock's dividend yield right now. If you want quality, sometimes the price you must pay upfront is a smaller starting yield than you might prefer. It can definitely be worth it in the long run.

James Brumley has positions in Coca-Cola. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.