The Sharp Stick

Evaluating Dividend Income Stocks – Current Yield versus Dividend Growth

2009-05-08T04:34:00.000-07:00

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 $
	Yield on Cost	Annual	Cumulative	Yield on Cost	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

2009-05-07T06:54:00.000-07:00

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?

2009-04-23T17:48:00.000-07:00

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!

Income please, hold the risk.

2009-04-23T09:06:00.000-07:00

As an individual investor focused on income producing equities, and someone who manages similar investments for others, one of the most important analyses I perform is an assessment of risk. I have come to live by the following… “Is it safe? Is it cheap?” Full credit for this mantra goes to Marty Whitman at Third Avenue Funds. Much has been written over time about “margin of safety” and the fact is that the best company in the world can be a lousy investment if you pay too much for it.

For my purposes, RISK is defined as the potential for permanent loss of capital and/or a long-term impairment in the value of the investment, and/or a significant impairment in the income production of the investment.
One of the portfolios I run belongs to a lovely woman in her mid-eighties (I’ll call her “Mom”). When he passed away a few years ago, her husband (I’ll call him “Dad”) left Mom pretty well off, and completely clueless regarding her financial situation. I took over management of her assets upon Dads’ death.

Needless to say, this one is a bit “different.” This is not just any client. As “Mom” says, I’ll never be too big or too old to keep her from swatting me on the back of the head if I screw up. Trust me... it’s not an experience you want to have.

“Mom” lives fairly frugally. She owns her home outright and is able to live comfortably off her Social Security and the RMD from her IRA. She has not had to touch any funds in her taxable investment accounts. The problem that I saw with her portfolio was that there was inadequate growth. Each year the RMD increased and portfolio income was not keeping pace, thereby causing a need to sell a portion of her investments each year in order to fund the RMD.

The recent massive decline in the stock market has presented a fabulous opportunity. A huge degree of risk has been removed from specific individual equity investments precisely because 1) prices are low because like a rising tide raises all boats, a falling tide does the opposite without regard for the seaworthiness of the ship, and 2) the outgoing tide has revealed many naked swimmers in the sea of the stock market. Please note that I do not know or care whether the “market” is over or under valued. Having bought and sold a couple of businesses in my career, I am comfortable valuing a business, not a market.

In the case of Mom, this ebb tide has allowed me to reallocate her retirement portfolio in such a way as to meet all of the following requirements:

Generate sufficient income to fund her RMD entirely out of income for several years
Provide for sufficient income growth to maintain portfolio income in line with required increases in her RMD
Provide the potential for (hopefully substantial) capital appreciation over time
Minimize the risks outlined in the second paragraph while achieving the above goals.

A final, secondary goal is the preservation and maximization of the value of Moms’ estate for her heirs (of which I am one, unless she changes the will) when the inevitable date arrives and she joins Dad in the great hereafter.

In trying to achieve these goals, I use individual dividend paying stocks for income, income growth and capital appreciation and I analyze each company I purchase for Moms’ portfolio from the following perspectives.

Is the company safe? Downturns come and go and I am not so much interested in current results as I am interested in the company’s’ ability to weather the downturns and continue forward without permanent impairment. The daily/weekly/monthly fluctuations in a company’s stock price are largely irrelevant. I look for companies with strong balance sheets and strong cash flows. Judging management has also become a bit easier when judging the safety of a particular company. While there is truth in the “rising tide" saying, the current economic situation has thrown a bright light on managements’ ability to navigate rough waters. In the words of Syrus Pubilius, “Anyone can hold the helm when the sea is calm." I want pilots who can handle the storms.
Is the dividend safe? Is it adequately funded out of cash flows and available cash on hand? Is it likely to remain so?
Will the dividend grow? Here there are two elements of concern. First is the long-term prognosis for the business. Can the company grow and increase its’ earnings and cash flows? Second is a demonstrated willingness on the part of the company’s board to increase the dividend more or less in line with the growth in the company’s earnings and cash flows.
What are the alternatives? Coke versus Pepsi as it were.
Is the price cheap and more importantly, is it cheap enough? Valuing a company will, if you are doing it correctly, produce a range of values, not an absolute number. Buying below this range provides a warm and fuzzy margin of safety to nestle in. I personally feel that the harder this analysis is to do and wider the range of values that are derived from the analysis, the less likely the answer to the above question is to be “YES.”

For any investment, I have a long-term target rate of return, which combines yield on cost, with anticipated growth and varies based upon my perceived risk that the investment carries. Another cliché (from Moms’ deep well of such things) is “Better safe than sorry.”

Finally, a word on DRIPs. I do NOT use DRIPs. I do not believe in “set-it-and-forget-it” investing. I whole-heartedly endorse reinvesting dividends but I would rather deploy excess cash based on my current analysis of investment alternatives. Frankly, all else being equal, my willingness to reinvest in a company is inversely proportional to the change in the price of the company’s stock price.

Where There's a Will... There's a Way

2009-04-22T12:27:00.000-07:00

Since the release of their quarterly earnings on April 21, and given managements’ statements regarding their full year outlook, there has been some speculation regarding whether Caterpillar, Inc. (CAT) will cut their dividend.

While a cut is always a possibility, a quick glance at their financials would seem to indicate that if they have the will, there is no need for a dividend cut at this juncture. Here is why:

CAT had over $3.5 billion in cash on their balance sheet at the end of Q1-09, an increase of $830 million from the end of 2008. In Q1-09 they paid out $253 million in dividends. This translates to roughly 14 quarters of dividend coverage at current levels.
Both Operating Cash Flow and Free Cash Flow were positive and were higher in Q1-09 than in Q1-08. The Dividend Payout Ratio on these two metrics was 28% and 38% respectively versus 32% and 61% in Q1-08.
CATs’ current ratio improved from 1.21 at the end of Q4-2008 to 1.34 at the end of Q1-2009

So while CATs’ current outlook for a full year profit of $1.25 before redundancy costs throws up the red flag of earnings being less than their annual dividend (currently at $1.68), their financial condition would seem to indicate that they have enough headroom to weather the current economic cycle without reducing the dividend… if they have the will.