Evaluating Dividend Income Stocks – Current Yield versus Dividend Growth

Dividend Growth Investing is by nature a long-term, value based, investment strategy. Once a target list of safe, cheap companies has been determined one must then, determine which to purchase. When choosing between two potential investments, one must, at some point, confront the issue of current yield versus dividend growth. The simple rule of thumb that says a stocks long-term return is equivalent to the yield on cost plus the dividend growth rate would seem to tell you that, all else being equal, all you need do is add these measures together to determine the better investment. Is this in fact the case?

The answer depends largely on the anticipated holding period for the stock. When evaluating two similar potential investments, I typically look at five and ten year holding periods and discount the income streams by 3% per year which is my long-term inflation assumption.

Let us look at a real world example:

Coke (KO) versus Pepsi (PEP)

On May 7, 2009, KO was trading in a range around $43.00 per share and has a dividend of $1.64 (Yield of 3.81%). PEP was trading in a range around $50.00 with a recently increased dividend of $1.80 (Yield of 3.60%) KO has a long-term record of increasing its dividend at a CAGR (compound annual growth rate) of 9.7%, while PEP over the same 10-year period has increased its dividend at a 12.4% CAGR

While the difference in initial yield between KOs’ 3.81% and PEPs’ 3.60% may seem insignificant in relation to the difference between their long-term dividend growth rates, the higher initial yield provided by KO outweighs the growth advantage that PEP offers for five years. After five years, the advantage goes to PEP.

	Initial Investment							$ 100,000
	LT Inflation Assumption							3%
	Company		KO	Company		PEP	Nominal Cumulative Income Differential	Inflation Adjusted Cumulative Income Differential
	Initial Yield		3.81%	Initial Yield		3.60%
	LT Growth Rate		9.70%	LT Growth Rate		12.40%
	Yield on Cost	Income $		Yield on Cost	Income $
		Annual	Cumulative		Annual	Cumulative
Year 1	3.81%	$3,810	$3,810	3.60%	$3,600	$3,600	($210)	($204)
Year 2	4.18%	$4,180	$7,990	4.05%	$4,046	$7,646	($343)	($329)
Year 3	4.58%	$4,585	$12,575	4.55%	$4,548	$12,195	($380)	($363)
Year 4	5.03%	$5,030	$17,604	5.11%	$5,112	$17,307	($298)	($290)
Year 5	5.52%	$5,518	$23,122	5.75%	$5,746	$23,053	($69)	($93)
Year 6	6.05%	$6,053	$29,175	6.46%	$6,459	$29,511	$337	$247
Year 7	6.64%	$6,640	$35,815	7.26%	$7,259	$36,771	$956	$751
Year 8	7.28%	$7,284	$43,099	8.16%	$8,160	$44,930	$1,831	$1,442
Year 9	7.99%	$7,991	$51,089	9.17%	$9,171	$54,102	$3,012	$2,347
Year 10	8.77%	$8,766	$59,855	10.31%	$10,309	$64,410	$4,555	$3,495
Year 11	9.62%	$9,616	$69,471	11.59%	$11,587	$75,997	$6,526	$4,919
Year 12	10.55%	$10,549	$80,020	13.02%	$13,024	$89,021	$9,001	$6,654
Year 13	11.57%	$11,572	$91,591	14.64%	$14,639	$103,659	$12,068	$8,743
Year 14	12.69%	$12,694	$104,286	16.45%	$16,454	$120,113	$15,827	$11,228
Year 15	13.93%	$13,926	$118,212	18.49%	$18,494	$138,607	$20,395	$14,160
Year 16	15.28%	$15,277	$133,488	20.79%	$20,787	$159,394	$25,906	$17,594
Year 17	16.76%	$16,758	$150,246	23.36%	$23,365	$182,759	$32,513	$21,591
Year 18	18.38%	$18,384	$168,630	26.26%	$26,262	$209,021	$40,391	$26,219
Year 19	20.17%	$20,167	$188,797	29.52%	$29,519	$238,540	$49,742	$31,552
Year 20	22.12%	$22,123	$210,921	33.18%	$33,179	$271,719	$60,798	$37,673

Admittedly, the differences in the above table are small and other considerations would likely outweigh them, but my purpose here is not to say that KO is a better income stock than PEP. Rather it is to provide one specific tool to use when evaluating a choice between two competing choices for an investors dollar.

Disclosure: Long KO

Is it Safe? Is it Cheap? Can it Grow? - General Dynamics

General Dynamics (GD) has been one of the highest ranked stocks on my screen for solid, dividend paying companies. Currently trading at under $55.00 per share GD has a current, indicated dividend of $1.52 per share and yields just under 3%. Over the past ten years, GD has generated a cash return on capital employed of roughly 16% and has a strong track record of increasing earnings.

As I look for companies that increase their dividends on a regular basis, a significant part of my analysis of a company relates to the financial condition that the company is in, specifically as it relates to their ability to pay and increase dividends.

At the end of Q1-2009 General Dynamics had:

• $1.1 billion in cash (equivalent to more than 7 quarters of dividend payments at its current rate. Cash decreased by roughly $500 million during the quarter primarily due to business acquisitions ($168M), Debt repayments ($139M), Dividends paid ($136M) and Stock purchases ($109M).

• A current ratio (Current Assets/Current Liabilities) of 1.2, which is in-line with its ten-year average.

• A Debt to Total Capital ratio of 27% down slightly from 29% at the end of 2008.

• A Sustainable Growth Rate (SGR), which is the theoretical maximum rate of growth the company can achieve long-term without accessing additional capital, of 15%.

GDs’ dividend payout ratios are very comfortable. The 2008 Payout ratios were 23% of earnings, 18% of operating cash flow, and 21% of Free Cash Flow, all of which match the companies’ 10-year medians. For the trailing 12 months ended April 5, 2009, the payout ratios were 23 % of earnings, 20% of operating cash flow, and 32% of Free Cash Flow.

While Morningstar calculates a Fair Value for GD of $65.00, my analysis tends to put a FV quite a bit higher. The range of FV metrics runs from a low of $68.00 based of price to book value to roughly $90 based on other metrics such as PE and Price to Cash Flow.

Discounted cash flow (DCF) values based on projected earnings and dividends range from the low $70’s to the mid $80’s

Over the past ten years GD has increased its’ earnings at an 11% compound annual growth rate, and has increased operating cash flow, free cash flow and dividends at a 12% CAGR.

The answer seems to be yes.

Disclosure: Long GD

What's the Discount?

In pretty much any endeavor that looks out toward the future, I take it as a matter of fundamental truth that while the devil may be in the details, he most certainly makes his permanent home in the assumptions. As any analysis of a business for investment purposes is fundamentally concerned with the future, one is confronted with the chore of using historical data to forecast “that which is likely to be.” When the analysis is concerned with a company’s earnings, the weapon of choice is the Discounted Cash Flow (DCF) model. When using discounted cash flow (DCF) analysis to determine a value for a stock, the two primary assumptions one must make are the earnings growth rate and the rate at which future cash flows should be discounted.

An earnings growth rate is very easy to come up with. You can look at a company’s historical performance and in the light of what you consider their future prospects to be, come up with an assumption, that if inaccurate (a synonym for assumption) at least has the illusion of reasonableness. Better yet, use a range of possibilities, thereby adding the illusion of thoroughness to the analysis.

The discount rate assumption, which is often nothing more than a screaming wild-ass guess (SWAG), is one that is better built from the ground up. This gives, not only the illusion of reasonableness but of statistical veracity as well. Here is how I come up with a discount rate.

First, since inflation will make tomorrow’s dollars worth less than they are worth today, a long-term inflation rate is entered into the mix. I use 3%

Next, add in a “risk-free rate of return.” I use the rate on ten-year treasuries, currently 3%. By the way; I round up. This isn’t rocket science, and more places to the right of the decimal adds zero accuracy… which would be the illusion of being an Economist.

To these figures, I add a simplistic weighted average cost of capital (WACC). This number is derived, for debt, by taking a company’s interest expense and dividing it by the debt load. For the equity portion of the WACC, I look at earnings yield. A hypothetical example using five years of data is as follows.

	2008	2007	2006	2005	2004
Average Mkt Cap	$ 16,650	$ 16,550	$ 15,600	$ 9,200	$ 6,500
ST Debt	$ 200	$ 25	$ -	$ -	$ -
LT Debt	$ 3,000	$ 2,250	$ 900	$ 1,600	$ 900
Total Debt	$ 3,200	$ 2,275	$ 900	$ 1,600	$ 900
Total Equity	$ 7,900	$ 5,000	$ 4,800	$ 4,300	$ 3,500
Total Capital	$ 11,100.0	$ 9,550.0	$ 6,600.0	$ 7,500.0	$ 5,300.0
Interest Expense	$ 135	$ 50	$ 40	$ 35	$ 25
Net Earnings	$ 1,800	$ 1,500	$ 1,800	$ 1,300	$ 1,100
						Mean
Interest Rate	4%	2%	4%	2%	3%	3%
Earnings Yield	11%	9%	12%	14%	17%	12%
WACC	9%	5%	9%	9%	12%	9%

In the above example, I have calculated a WACC of 9% to which I add the previously assumed inflation rate and the risk free return rate, yielding a final discount rate of 15%. Now off to the forecasting races!