Estimating Future Dividend Growth

Estimating future dividend growth is difficult if not impossible. Companies which might have had a long history of consistent double digit increases might stop raising dividends and might even cut them. It is easy to predict whether or not a company’s dividend is sustainable in the short run, by evaluating EPS trends, dividend payout ratios and cash flows. It is difficult to forecast however whether the dividend won’t be cut several years down the road.

Financial companies such as Bank of America (BAC) and US Bancorp (USB) are two prime examples of this. After raising distributions for several decades, and always spotting above average dividend yields, the companies had to cut dividends amidst the global financial crisis of 2007-2009. The stocks were often priced attractively before 2006-2007, with adequately covered dividends, attractive valuations and very good current yields at the time. Fast forward two years and these former dividend darlings have cut their dividends sending retiree’s alternative incomes into a tailspin.

While it is somewhat easier to predict short term movements in dividends, based off the actions in recent years, astute dividend investors need to be aware of the warning signs of a potential dividend cut or freeze.

First, if a company stops producing earnings growth, then chances are that dividend growth would be limited.

Second, if the company has taken on too much debt, it might end up cutting dividends in order to free some cash flows to repay creditors and avoid going under. If the company is already spotting an unsustainable dividend payout ratio out of earnings, chances are that dividends are due for a cut.

Third, while sometimes companies fall on hard times, management could keep raising distributions. This could be due to management’s vision that this setback in company’s fortunes is temporary. In such cases it might be unwise to sell your position, as long as the dividend is at least maintained. If management keeps borrowing money however for over 2 years in a row in order to finance the dividend, this is a warning sign.

And last but not least, while a company might look as a great promising addition for your dividend portfolio, remember to diversify across sectors, yield/growth characteristics and even countries, in order to reduce your portfolio’s systemic risk. Investors who were heavily invested in the financial sector in 2007 and 2008 suffered huge drops in income; investors who held a more balanced mixture of stocks from a variety of industries suffered lower drops in dividend income.

I recently added to my positions in the following stocks, which have recently raised distributions, trade at attractive valuations and have a long history of dividend growth.

Johnson & Johnson (JNJ) engages in the research and development, manufacture, and sale of various products in the health care field worldwide. The company, which has rewarded shareholders with consistent dividend raises for 47 years, currently yields 3.20%. Using the ten year dividend growth rate for the company at 13.3%, yield on cost on an investment today would double almost every five and a half years on average. (analysis)

The Procter & Gamble Company (PG) engages in the manufacture and sale of consumer goods worldwide. The company operates in three global business units (GBUs): Beauty, Health and Well-Being, and Household Care. The company has raised distributions for 53 years in a row, and currently yields 3.10%. Using the ten year dividend growth rate for the company at 10.7%, yield on cost on an investment today would double almost every seven years on average. (analysis)

McDonald’s Corporation (MCD), together with its subsidiaries, franchises and operates McDonald’s restaurants in the food service industry worldwide. The company has raised dividends for 33 consecutive years and currently yields 3.90%. Using the ten year dividend growth rate for the company at 27.4%, yield on cost on an investment today would double every two and a half years on average. (analysis)

Emerson Electric Co. (EMR), is a diversified global technology company, engages in designing and supplying product technology and delivering engineering services to various industrial and commercial, and consumer markets worldwide. Emerson, which currently yields 3.40%, has raised distributions for 52 years in a row. Using the ten year dividend growth rate for the company at 6.3%, yield on cost on an investment today would double every eleven and a half years on average. (analysis)

PepsiCo, Inc. (PEP) manufactures, markets, and sells various snacks, carbonated and non-carbonated beverages, and foods worldwide. Pepsi has raised distributions for 37 years in a row, and currently yields 2.90%. I would consider adding to my position there on dips below $60. Using the ten year dividend growth rate for the company at 12.8%, yield on cost on an investment today would double every five and a half years on average. (analysis)

Disclosure: Long JNJ, PG, MCD, EMR and PEP

Comments

[mbkelly75:]

Very nice - well written and clearly put. I am doing the same thing for the same reasons as well as re-investing the dividends in the company that paid them as they come in (usually - there are times when I need cash - but the general rule is to re-invest).

Nov 06 10:47 AM

[notsosmart:]

drip plans in good cos that pay a reasonable div & you buy @ a low price is the only way to beat the wall st ponzi/casino.if you have time on your side & put up with boring investing the pay off is great.it worked great for me.some cos let you buy their stock directly.saving on fees can add up.

Nov 06 12:14 PM

[ndallasj:]

Although I agree with (and practice) the basic underlying philosophy espoused in the article, to project a valuation based upon historic dividend growth rates is also dangerous. For instance, there is NO WAY that MCD will continue to raise dividends at 27% per annum over the next ten years.

Nov 07 09:37 AM

[Dotcom:]

I own JNJ & MCD and reinvest the dividends.

I have PG, EMR and PEP on my radar, but they look too expensive at this time.

I would appreciate some data/opinions on entry point prices for these.

Side note: Is there a way to be notified by email on Seeking Alpha, when someone updates a "post" like this one vs. Having to refresh and recheck the page?

Thanks

Nov 07 02:55 PM

[David Van K...:]

I reinvest dividends too, but not necessarily in the company that paid them. I consider accumulated dividends as "new money," and believe that where to invest it deserves the same careful consideration that any investment deserves. Therefore, I let the incoming dividends accumulate to $1000, then investin the best current opportunity. Among other things, that helps give me the chance to catch a company when it is undervalued for some reason (which usually goes hand-in-hand with a higher current yield). It also lets me avoid reinvesting in some companies that, for whatever resaon, are no longer the compelling opportunities they were when I first bought them.

Sometimes the reinvestment goes into one of the companies I already own, while other times I may add a new company to my dividend portfolio. One way I assess where to put the new money is to favor stocks that have recently raised their dividend by a healthy amount. A company that just raised its dividend by, say, 12% is making a confident statement about its future. Companies with long records of raising their dividends do not want to raise it to a level that they will have to freeze at, or cut from. So a healthy dividend increase suggests that they don't see any near-term clouds on the horizon.

Nov 07 03:02 PM

[mbkelly75:]

It is also a good way to do it and you make a good point. My broker re-invests the dividends in the stock that paid them commission-free and that helps to make it attractive for me. I am basically a long-term investor and this is a painless way of lowering my cost-basis on the stock. I check to see if my portfolio needs re-balancing every 2 (two) weeks so if I get more of a stock than I actually need - re-balancing takes care of it. Both ways work well - the key here is to re-invest the dividends.


On Nov 07 03:02 PM David Van Knapp wrote:

> I reinvest dividends too, but not necessarily in the company that
> paid them. I consider accumulated dividends as "new money," and believe
> that where to invest it deserves the same careful consideration that
> any investment deserves. Therefore, I let the incoming dividends
> accumulate to $1000, then investin the best current opportunity.
> Among other things, that helps give me the chance to catch a company
> when it is undervalued for some reason (which usually goes hand-in-hand
> with a higher current yield). It also lets me avoid reinvesting in
> some companies that, for whatever resaon, are no longer the compelling
> opportunities they were when I first bought them.
>
> Sometimes the reinvestment goes into one of the companies I already
> own, while other times I may add a new company to my dividend portfolio.
> One way I assess where to put the new money is to favor stocks that
> have recently raised their dividend by a healthy amount. A company
> that just raised its dividend by, say, 12% is making a confident
> statement about its future. Companies with long records of raising
> their dividends do not want to raise it to a level that they will
> have to freeze at, or cut from. So a healthy dividend increase suggests
> that they don't see any near-term clouds on the horizon.

Nov 09 09:28 AM

[ValueBarbar...:]

What about predicting future dividend growth by focusing on situations where dividends are CUT (for the right reasons). I've done very well this year buying MLPs that have sound, but overlevered businesses, after a distribution cut in order to pay down excess debt.

Many of these situations are paying predictably low distributions as they pay down debt. However, after the debt load is reduced on these MLPs they're capable of paying out 20-30% distribution yields.

My three favorite this year have been BBEP, EROC, and CEP. I think EROC is quite suitable for new money, as this partnership typically pays out the majority of its cashflow, and it trades at about 2-3X cashflow this should offer a great potential for a long term (if somewhat volatile) high distribution yield. CEP is perhaps more of a cheap long term call option on natural gas.

The great thing about this strategy is that you can buy companies when no one wants them, and then collect a high yield on cost plus capital gain.

Nov 09 11:33 AM

[mbkelly75:]

Entry Points kinda depend on what you are looking for. As an example, PG has been raising their dividends for 55 years and it is 2.85% annually even at today's price of 61.86. I know people who are happy with 2.5% dividends from a company with rising dividends longer than 10 years. They are trending up and would be a buy right now for them. I know people who like 3% - If PG drops down to $58.67, that would be their entry point. I like P/S below 1.0 for a bottom-fishing buy point - PG's P/S = 2.34 - so they would have to drop quite bit or really make better sales (or both) to reach that point. It depends on what you are looking for and would be happy with long-term. Another entry point might be waiting until they hit a down-cycle and buying them when they start trending up again. That would be Ben Graham's advice. The Graham's Number method does not work well with Large Caps, but that part of the general idea is good here. Moving Averages would point that out easily for you. Their Price / Free Cash Flow Ratio is 23.13. An Entry Point using that would be =<15. That price would be $43.87 or less. There is a variety of ways to pick an entry point. Use one that works well with your method of picking stocks and that you are comfortable with. I like a 3% dividend from a stock that is trending up. If they dip back down to $58.67 - I would buy on the dip.

On Nov 07 02:55 PM Dotcom wrote:

> I own JNJ &amp; MCD and reinvest the dividends.
>
> I have PG, EMR and PEP on my radar, but they look too expensive at
> this time.
>
> I would appreciate some data/opinions on entry point prices for these.
>
>
> Side note: Is there a way to be notified by email on Seeking Alpha,
> when someone updates a "post" like this one vs. Having to refresh
> and recheck the page?
>
> Thanks

Nov 10 06:35 PM