Seeking Alpha
Value, long-term horizon, dividend investing, dividend growth investing
Profile| Send Message|
( followers)  

Introduction

As I mentioned in my introduction article under the "my business plan basics" section (here), I am doing my best to focus on dividend growth investing. My goal is to replace a portion of my required retirement need with income from dividends. As a goal, I would like to have $40k (in today's dollars) come from dividends when I retire in 30 years. This represents about 40% of the need from 33% of the start up cash from the portfolio. Obviously, I am long Dividend Growth Investing.

While reading a great article by Mike Nadel (here), it brought up an interesting question. The problem I have is around understanding the potential dividend income that I could have from a portfolio of dividend growth stocks that are going to compound over the next 30 years. In most DGI overviews, the assumption is that the dividend growth rate is equal to the stock price appreciation rate. Thus, when a purchase is made with dividends, the purchase is made at the then current fair value equal to the average, straight line adjusted, previous purchases up to that point adjusted by the dividend growth rate. Additionally, the models generally makes the assumption that any volatility over time in the stock price is negligible. We all wish that was true, but we all know better than that.

Below are a couple of views of the problem of forecasting the valuation of future dividends from historic dividend growth values and a look back at four stocks real performance in terms of dividend and capital appreciation. I have selected examples that show each of the following:

  1. Share Price and Dividend Growth are about the same - McKormick & Co. (MKC)
  2. Dividend Growth outperforms the Share Price - McDonald's (MCD) / Johnson & Johnson (JNJ)
  3. Share Price outperforms the Dividend Growth - Chevron (CVX)

Each will be compared to applying the dividend growth rate equally to the share price as defined below in the Standard Approach section.

The Standard Approach

If I were to look at the historic performance of McCormick and Company over the past 5 years, I would see the following:

Current Price: $69.31

Current Dividend: 1.96%

5 Year Dividend Growth Rate: 8.8%

If I were to model this for a 30-year period, it would look like the following:

Start

Year 10

Year 20

Year 30

Cash Value

$10,000

$14,933

$30,087

$76,636

Price

$69

$161

$374

$870

Shares w/ Reinvest

144

191

252

333

Dividend

$2

$5

$11

$25

Div Paid No Reinvest

$283

$657

$1,528

$3,551

Div Paid Reinvest

$283

$869

$2,668

$8,197

With a base of $10,000, the first year would produce an income stream of $283. After 30 years, this income stream, with dividend reinvestment, would grow to $8,197 not adjusted for inflation. That doesn't sound too bad! The share count would grow from 144 shares to 333 shares and would have value of just over $76k. This is a pretty good capital appreciation rate of 7% CAGR and an 81% yield on cost.

The above is based on purchasing a stock at the same share price of the year in which the dividends are earned. If instead I alter the model to make the purchase at the incremental share price (equal to dividend growth), then the model would result in the following:

Start

Year 10

Year 20

Year 30

Cash Value

$10,000

$14,874

$29,517

$73,507

Price

$69

$161

$374

$870

Shares w/ Reinvest

144

186

241

312

Dividend

$2

$5

$11

$25

Div Paid No Reinvest

$283

$657

$1,528

$3,551

Div Paid Reinvest

$283

$850

$2,552

$7,667

With a base of $10,000, the first year would produce an income stream of $283. After 30 years, this income stream, with dividend reinvestment, would grow to $7,667 not adjusted for inflation. The share count would grow from 144 shares to 312 that would have a value of just over $73k. Both, of course, have the same value for non-reinvested dividends that is beaten significantly by reinvesting the dividends. As you notice, between the two models, the count of shares is 6% higher in the first example where the purchase price lags the growth in the dividend. This small fluctuation in the price applied consistently shows a pretty different picture.

Because of this gap, I thought it would be interesting to review a few real stocks to determine the potential range of impact across the business cycle.

The Real World

To simplify the data requirements, I am going to look at 10-year histories of each stock applying a quarterly dividend and reinvestment into the same stock near the day that the dividends were paid. These values will then be compared to the flat 10-year, non-volatile growth rates applied at the dividend growth rate consistent with the second example above.

Note: All values are rough approximations from Google Finance. Any adjustment from splits has been calculated via Google Finance. The time frame reviewed was Q1 2002 to Q1 2012.

McCormick

McCormick is an example where share price appreciation is near the growth rate of the dividend.

Start

Year 10

<- CAGR

Straight Line 10 Year

<- CAGR

Cash Value of Shares

$10,000

$32,271

12%

$35,856

14%

Price per Share

$21.01

$54.40

10%

$62.03

11%

Shares Owned

476

593

--

578

--

Dividend

$0.11

$0.31

11%

$0.31

11%

Dividends
Collected (qtr)

$49.98

$183.90

14%

$179.19

14%

To reduce space, note that I have limited the column names. The CAGR columns are in reference to the Year 10 value that are immediately to the columns left.


(Click to enlarge)

The value of the shares starts with the same $10k as above. Over the 10 years, the value grew to $32k representing 12% CAGR. This was outpaced by the 14% CAGR of the dividend paid which went from $49.98 for the first quarter to $183.90 during the last quarter. When applying the dividend growth rate to match the price appreciation in shares, it results in fewer total owned shares over the 10 years. This generates a lower dividend payment, but reaches a higher price appreciation. This is an example where little trade off is made between the sample model and the actual results.

The chart shows the cash value of the shares (blue line, left axis), the share price (red line, right axis) and the dividend paid during the quarter (green line, right axis). As you can see, the blue and green lines start and end almost in identical places.

McDonalds

McDonalds is one of those great examples where if you run the calculation incorrect and it tells you to retire the next day. Then 10 years later you go bankrupt. It is an example where the share price appreciation underperforms the dividend growth rate.

Start

Year 10

<- CAGR

Straight Line 10 Year

<- CAGR

Cash Value of Shares

$10,000

$48,769

17%

$129,695

29%

Price per Share

$26.16

$100.32

14%

$311.69

28%

Shares Owned

382

486

--

416

--

Dividend

$0.06

$0.70

28%

$0.70

28%

Dividends
Collected (qtr)

$22.46

$340.29

31%

$291.27

29%

Reminder - the CAGR columns are in reference to the Year 10 value that are immediately to the columns left.


(Click to enlarge)

Note: From 2002 to 2007 MCD paid a dividend on an annual basis. The calculation was compounded on the dividend payment date. The start numbers above have been adjusted to reflect the equivalent value of a quarterly payment for visualization only. The same is applied to the Total Quarter Dividend line (green line) in the chart above.

Starting with the same $10,000 value, you see that after 10 years the value of the stock has increased to $48k with a CAGR of 17%. As a divergence, you see the dividend outpaced the growth of the share price resulting in a payment of $340 with a CAGR of 31%. If you apply this CAGR to equal share appreciation, you can see that you are completely mislead. The value of applying the same dividend CAGR to the share price appreciation results in a calculated share value of $129k. This results in a ridiculous value that is 165% higher than reality. This also results in a lower dividend payment of $291 vs. the $340. This is an example where it is obviously important how you complete the estimates used in the model.

The chart shows the cash value of the shares (blue line, left axis), the share price (red line, right axis) and the dividend paid during the quarter (green line, right axis).

Johnson and Johnson

JNJ is a similar example to McDonalds in that share appreciation lags dividend growth rates. This example shows a more conservative stock than the great growth in McDonalds and may represent a better comparison example for this exercise.

Start

Year 10

<- CAGR

Straight Line 10 Year

<- CAGR

Cash Value of Shares

$10,000

$14,461

4%

$35,782

14%

Price per Share

$57.24

$64.46

1%

$181.26

12%

Shares Owned

175

224

--

197

--

Dividend

$0.18

$0.57

12%

$0.57

12%

Dividends
Collected (qtr)

$31.45

$127.87

15%

$112.52

14%

Reminder - the CAGR columns are in reference to the Year 10 value that are immediately to the columns left.


(Click to enlarge)

Starting with the same $10,000 value, you see that after 10 years the value of the stock has increased to only $14k with a CAGR of 4%; share price growing only 1% CAGR. On the dividends collected side, the growth rate has shown a pretty good rate of growth at 15% CAGR. Similar to MCD, the straight-line exercise results in an aggressive share price valuation that is misleading. While not a 'retire tomorrow' value like McDonalds, it does show an example of how the resulting end valuation for shares can be overstated by 100%.

The chart shows the cash value of the shares (blue line, left axis), the share price (red line, right axis) and the dividend paid during the quarter (green line, right axis).

Chevron

Note: This is a harder example to find. The time frame was moved from the matching time frame of the other examples (Q1 2002 to Q1 2012) to an alternative time frame. The result holds true over the original time frame. The alternate time frame that was selected is Q3 2002 to Q3 2012. This selection was made in order to exaggerate the results.

Unlike the previous two examples, CVX represents a case where the share value CAGR outperforms the divided CAGR.

Start

Year 10

<- CAGR

Straight Line 10 Year

<- CAGR

Cash Value of Shares

$10,000

$40,954

15%

$36,645

14%

Price per Share

$38.46

$112.66

11%

$98.90

10%

Shares Owned

260

364

--

371

--

Dividend

$0.35

$0.90

10%

$0.90

10%

Dividends
Collected (qtr)

$91.00

$327.17

14%

$333.49

14%

Reminder - the CAGR columns are in reference to the Year 10 value that are immediately to the columns left.


(Click to enlarge)

Starting with the same $10,000 value, you see that after 10 years the value of the stock has increased to almost $41k with a CAGR of 15%. On the dividend side, the growth rate has shown a pretty good rate of growth at 10% CAGR. The variance between the actual and the straight line here is interesting to note. In this case, the straight line underperforms the cash value of shares and only slightly beats the dividends collected.

The chart shows the cash value of the shares (blue line, left axis), the share price (red line, right axis) and the dividend paid during the quarter (green line, right axis).

Conclusion

For a DGI, the ultimate goal is to meet their target payout. For me, that value is $40k (in today's dollars) and I have the next 30 years to figure it out. When I look to model the expected value generated from a stock, I do not model the price appreciation to be equal to the stock growth rate. Instead, I take a look at the growth of the stock price independent of the dividend growth rate.

In doing research for this article, I found the most likely scenario to be that in which the dividend growth outpaces the share price appreciation. This would be along the lines of the examples for MCD and JNJ. This is probably more a testament to the selected time range (2002-2012) more than anything else. I am of course interested in hearing the comments from your experience.

In the end, the question is should an investor even care? It is two sides of a good coin when you select quality businesses that grow in value over time. Either you get poor quality return on your capital that allows you to accumulate a vast count of total shares at a cheap price relative to the company earnings (assuming you bought cheap) with a solid dividend payment on those shares or you get fantastic capital appreciation, but low dividends. While it is the goal of a DGI to shoot for achieving the former, the latter is not something that would cause too many complaints. As a DGI, it feels better to get the value from dividends. This is where it is important to know your personal goals and invest on their behalf.

Source: Manage Your Expectations When It Comes To Forecasting Future Dividends