This is a guest contribution written by Ben Reynolds at Sure Dividend. Sure Dividend uses The 8 Rules of Dividend Investing to systematically find high-quality dividend growth stocks trading at fair or better prices.
Investing concepts can seem divorced from reality. Theories become more understandable through real world examples.
This article takes a look at 3 important dividend investing concepts and provides real world examples to help either explain the point or show evidence of why it matters.
Total return measures exactly what the name implies. Total return includes the capital appreciation and dividends of an investment.
The concept of total return is critical to investing success. It is the one number that determines how quickly your money will grow. All other things being equal, the higher the total return, the better. Here’s how you can double your money.
Calculating a reasonable expected total return will help to guide your investing decisions.
Returns in the market can come from only 3 places:
- Change in intrinsic-value-per-share (typically measured by earnings-per-share growth)
- Change in valuation multiple (typically measured by the price-to-earnings multiple (P/E))
My estimate of The Coca-Cola Co’s (NYSE:KO) total returns over the next 5 years is below.
First, we know the company’s dividend yield is 3.2%. The company is a Dividend King – it has paid increasing dividends for over 50 consecutive years. We can reasonably assume Coca-Cola will continue paying dividends.
3.2% a year is our expected return from dividends for Coca-Cola.
Coca-Cola is currently trading at a P/E of 20.7 using adjusted earnings. The company’s 10-year historical average P/E is 18.6. If we expect the company to return to its historical P/E of 18.6 over the next 5 years, we can expect returns of -2.1% a year from valuation multiple changes.
-2.1% a year is our expected return from valuation multiple changes for Coca-Cola.
Coca-Cola has compounded earnings-per-share at 7% a year over the last decade. Management expects 5% long-term growth before share repurchases. Coca-Cola has repurchased around 1% of shares outstanding (after dilution from share issuances) over the last decade. We can reasonably expect Coca-Cola’s earnings-per-share to grow at around 6% a year going forward.
6.0% a year is our expected return from intrinsic-value-per-share changes for Coca-Cola.
Adding up the 3 sources of total return, our expected total returns for Coca-Cola are 7.1% a year. At 7.1% a year, your money will double about once a decade. If this is a reasonable rate of return for you (factoring in the low risk of Coca-Cola’s business model), you would invest in Coca-Cola.
The payout ratio is an extraordinarily simple metric. It is calculated as dividends divided by earnings.
The concept behind payout ratio is very powerful, however. You can use the payout ratio to help reduce the risk of suffering a dividend cut or elimination in your investment.
The lower the payout ratio, the safer a company’s dividend is, all other things being equal. A business with a 95% payout ratio may be forced to cut its dividend if operations experience any type of hiccup. In the real world, there is always going to be another ‘hiccup’.
To show the importance of the payout ratio, we will compare 2 businesses with different payout ratios:
- Target Corporation (NYSE:TGT) has a payout ratio of 41%
- Caterpillar Inc. (NYSE:CAT) has a payout ratio of 164%
Target pays out a reasonable amount of its earnings as dividends. The company’s conservative payout ratio means management can increase the dividend safely – even if earnings decline a bit.
Caterpillar’s payout ratio of 164% shows the company cannot cover its dividend with earnings. Management will either have to cut its dividend, or pay it out of cash on hand or debt.
A high payout ratio alone does not guarantee a dividend cut. On deeper analysis, I don’t think Caterpillar is due for a dividend cut soon. The point is, whenever you see a high payout ratio – and especially one above 100% – the dividend is not guaranteed and deeper analysis is required.
In the example above, Target’s dividend is far safer than Caterpillar’s. Target investors can reasonably expect years of rising dividends.
Caterpillar shareholders should be more nervous about the future of the dividend relative to Target shareholders.
For a company to pay its shareholders dividends (and preferably rising dividends), it needs 2 things:
- The ability to pay dividends
- The willingness to do so
The payout ratio measures the ability of a company to pay out a dividend at any point in time. As discussed above, the lower the payout ratio, the better.
The second part of the equation is that management is willing to pay – and better yet, prioritize – the dividend. Learn how to boost your income safety.
Can Alphabet Inc (NASDAQ:GOOG)(NASDAQ:GOOGL) pay out a dividend? Absolutely. But it doesn’t because that is not a priority for its management.
Dividend history matters. It creates a sort of managerial inertia. No one wants to be the CEO who stopped the company’s multi-decade streak of rising dividends.
Once a business has the ability to pay dividends, it must have a management team that will use cash to do so – instead of expanding the business, which could lead to higher executive compensation. Paying dividends shows that a management team is trying to reward shareholders.
The real world example of the performance of businesses is exemplified by a select group of 50 stocks that have paid increasing dividends for 25+ consecutive years. This group is called the Dividend Aristocrats.
You would expect shareholder friendly managements of businesses with the ability to pay rising dividends year after year to produce superior total returns… And that’s exactly what has happened. The Dividend Aristocrats index has produced annualized total returns of 11.0% a year over the last decade – versus 7.8% for the S&P 500.
Want to learn more about dividend growth investing? Don’t miss these dividend growth investing concepts on Passive Income Earner.
Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.
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