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By Brian Nelson

Many investors use dividend growth investing as a means to generate income for their portfolios. We think it's important to understand how dividends impact valuation, why we like dividend growth investing (which may be different than why other professional research firms do), and we'd also like to offer three dividend growth ideas for consideration - all in the spirit of wanting you to get the most out of your investments. In this article and for analytical purposes, we use dividend and distribution interchangeably, even though the tax implications for investors are different.

To get started, let's first conceptualize income transfer versus value creation in a simple example.

Income Transfer versus Value Creation

Bear with us as we walk through a very straightforward example first, and then we'll move into more real-life situations.

Let's imagine for a minute that you gave $1,000 to your co-worker for a piece of paper, and the co-worker said that in exchange he or she would pay you a $1 a year and increase the payment 5% each year into perpetuity until the $1,000 ran out. At any time, you could give the paper back, and your co-worker would return the remaining money to you in full.

Absent the time value of money (i.e. the discount mechanism that links the value of tomorrow to today), what is the value of this relationship to you? And when he or she pays you more and more each year, should you grow more and more excited about it?

The answer to the first question is that the relationship to you isn't really worth anything. You could have $1,000 right now by giving the paper back or your co-worker would eventually provide you with an annual income stream until you finally receive $1,000 in its entirety in the future. Absent the time value of money, these two scenarios are equal. Raising the payout to you each year shouldn't make you more or less excited in this example.

The only real value of this relationship is if somehow your co-worker would be able to grow the $1,000 you gave him for your benefit. If instead, for example, let's say the co-worker would replace all payments that are given to you with his or her own personal earnings such that at any time he or she would have $1,000 to give to you in exchange for the paper. That would be fantastic! Then the value of this relationship to you would be a growing perpetuity function: [$1 * (1.05)]/0.05 = $21. Essentially, the co-worker is creating $21 in value for you because he is generating earnings for you, assuming a 10% discount rate (for illustrative purposes).

The value of a relationship where one party pays an income stream to another is not in the income stream itself, but in the actions one party takes to replenish that income stream such that it can continue to be paid in the future. Said differently and perhaps in more relevant terms, the value of a dividend-paying firm is not in the income itself, but in the actions the dividend-paying firm takes to replenish that income stream such that it is sustainable.

A Real-life Example

Let's say you bought 1,000 shares of Southern Company (NYSE:SO); it would cost you about $41,100 at today's prices, excluding commissions. The company pays out $2.03 per share in annual dividends, so each year you would receive about $2,000 plus the growth in the payout. Assuming the utility grows its dividend at a 2% annual clip, it would take about 20 years for you to receive all of your money back from dividends. If no further transactions are performed, the firm has simply transferred the money you invested in it back to you over this time period. The only value accruing to you as a shareholder of Southern Company through Year 20 is the earnings and cash flows generated by the firm to replace the money it has paid out as dividends to you over the years. This value would be reflected in its stock price in Year 20, which will be based on future expectations of earnings and free cash flows at that time.

Said differently, what Southern Company pays as dividends to you is not a source of value - the company is simply paying the money you've invested in it back to you. Value, instead, is generated by the earnings that replace the income stream that Southern Company provides to you. The transfer or the structuring of income from one party to another is best described as a source of convenience (or inconvenience depending on tax rates), but it is not a source of economic value creation.

How Dividends Impact Valuation

Let's walk through the valuation adjustments we perform when a firm pays a dividend. Let's use Dividend Aristocrat 3M (NYSE:MMM) in this example. Below, please find the company's valuation breakdown, as of its report dated December 25, 2013.

Image Source: Valuentum

There are two items that we'd like you to focus on in this example (image above): the line item 'Net Balance Sheet Impact', which is -$2.285 billion (negative $2.285 billion) and the line item 'Diluted Shares Outstanding,' which is 703.3 million shares.

Both of these figures can be found in 3M's most recent annual report 10-k (click here, see pages 47 and 48). It is a large document so it may take some time to show up on your screen. On page 47 of that document, you'll see the denominator we use in valuation, 'Diluted Shares Outstanding': 703.3 (million). It can be found near the bottom of the income statement.

On page 48, you'll see how we arrive at the 'Net Balance Sheet Impact': cash and cash equivalents ($2.883 billion) + marketable securities ($1.648 billion) less long-term debt ($4.916 billion) less short-term borrowings ($1.085) and less two additional items we adjust for: capital lease obligations ($71 million) and the underfundedness of the company's pension ($744 million) or our estimate of its current funding status (the pension was more than $1.9 billion underfunded at the end of 2012, page 79).

Net Balance Sheet Impact = $2.883 + $1.648 - $4.916 - $1.085 - $0.071 - $0.744 = -$2.285

On December 17, 3M significantly increased its quarterly dividend to $0.855 per share from $0.635 previously (see history here; press release here). The same day the company issued another press release: "3M Affirms Long-Term Sales and Earnings Growth Objectives, Addresses 2014 Outlook." Even though 3M reaffirmed its long-term sales and earnings growth objectives (no news) and issued a 2014 outlook of $7.30-$7.55 per share, bounding the consensus estimate of $7.40 per share (in-line outlook), shares rocketed higher. The dividend increase (not better than expected future value creation) has propelled 3M's shares from being slightly overvalued to irrationally over-priced-all because of a higher income transfer to shareholders (a higher pass through of cash that the shareholder owned anyway).

Assuming that there will be 703.3 million shares outstanding at the time the company goes ex-dividend (2/12/14), the cash transfer from the company to the shareholders would be $601.3 million; 703.3 million x $0.855. Therefore, the new value of 3M, using the balance sheet as the adjustment factor (since dividends are paid in cash), would be ratcheted down by $601.3 million. The "Net Balance Sheet Impact" becomes a larger 'negative' and the equity value of 3M would go from $73.3 billion (see image above) to $72.7 billion, and the fair value estimate would be $103.375 per share. You'll notice that the valuation adjustment is precisely the amount that the company pays to shareholders in cash.

The only way that 3M can increase our estimate of its fair value is if it drives better-than-expected earnings and free cash flows (relative to our forecasts), which would increase the discounted value over our three-stage model and bolster total firm (enterprise) value. Dividends are a transfer of cash to the shareholders that the shareholders owned anyway (1). Said differently, shareholders owned the cash paid out in dividends whether the company holds it or they hold it. Increasing a dividend is not a value-creating endeavor.

(1) Special example: Paying a dividend can be value-creating if the management team had plans to destroy value via an acquisition or other endeavor with the cash it otherwise used to pay the dividend.

Why Did 3M's Stock Price Increase (in our opinion)?

Stock prices can move around for a large number of factors. We think the popularity of dividend growth investing as a style, 3M's well-known participation in the Dividend Aristocrat list, and the magnitude of the dividend increase (35%) were all contributing factors. 3M now yields 2.5% and the size of the increase may have pushed some dividend growth investors to diversify into its stock on hopes of further dividend increases.

Though we agree that 3M's Valuentum Dividend Cushion score indicates a strong potential for additional dividend advances, 3M has not created value by this move, and we believe the rapid surge in its equity price (through January 14, 2014) is based entirely on the speculation of a non-value creating event: future dividend increases. To us, 3M is a fantastic company with excellent dividend growth prospects, but its shares are irrationally overpriced because of the same reasons.

Why Do We Like Dividend Growth Investing?

We think dividend growth investors are quite savvy, especially when they combine a rigorous dividend growth process in the form of the Valuentum Dividend Cushion with the valuation rigors behind the Valuentum Buying Index. Let's examine the three reasons why we like the investing style.

#1. Fool Me Once, Shame on You … Fool Me Twice, Shame on Me

Today's dividend growth crowd has seen enough. First, they witnessed the dot-com bubble (1997-2000), a period in stock market history where firms' stock prices soared in some cases as a result of just adding an "e-" prefix to their names or a ".com" at the end. Today's dividend growth investors then witnessed these same firms' share prices fall precipitously (Infospace's shares fell from $1,305 to $22 each), and in other cases, saw complete company failures (Pets.com, Boo.com, GovWorks.com).

Shortly thereafter, today's dividend growth crowd heard about the Enron scandal and the dissolution of Arthur Andersen, followed by Worldcom and Tyco International -- unfortunately, the list goes on and on. The accounting scandals added to the distrust of companies that was only exacerbated by the conflicts of interest brewing within the global financial system. Today's dividend growth investor was nearing the breaking point.

The Global Settlement in 2003 finally separated the investing banking and analysis departments at the largest investment banks, but this wasn't enough. Today's dividend growth crowd still doesn't believe sell-side research from investment banks is completely free from conflicts of interest. After all, how could it be when sell-side researchers still get paid based on commissions crossing their trading desks? Today's dividend growth crowd knows that sell-side analysts are just that: sales people. Today's dividend growth investor only trusts independent research from firms that are free of bias, firms like Valuentum.

If the scandals of yesteryear weren't enough for today's dividend growth crowd to completely abandon the stock market at that time, they then witnessed the real estate bubble through the latter part of last decade and the collapse of equity prices during the Great Recession. The fall of Lehman Brothers and Washington Mutual and the collapse of AIG (NYSE:AIG) and General Motors (NYSE:GM) coupled with the terrible ratings assigned to certain tranches of MBS by the credit rating agencies only deepened the distrust that had been brewing within today's dividend growth crowd since the beginning of this century. When the S&P 500 bottomed under 700 in March of 2009, that was it!

"Fool Me Once, Shame on You … Fool Me Twice, Shame on Me" - says today's dividend growth investor.

#2. Dividend Growth Investors Act as Business Owners

After being burnt by the stock market one too many times, today's dividend growth investor no longer accepts the idea that capital appreciation is the only way to gain long-term wealth in the stock market. Instead, today's dividend growth crowd has learned the power of compounding cash flows in the form of dividends. After all, seeing the dividend check hit their bank account is real - what an analyst at a sell-side shop says may or may not be the real deal.

Just like a business owner invests the cash flows of the business to generate even more cash, today's dividend growth investor wants to re-invest dividends to generate even more dividends. Today's dividend growth investor is no longer betting on long-term capital appreciation in a stock market that has worked against investors for the past few decades, but instead today's dividend growth investor is assessing the strength and safety of a firm's dividend via the Valuentum Dividend Cushion to ensure that these cash flows can be paid in the future. Today's dividend growth investor views dividends much like a business owner views free cash flow.

And just like Warren Buffett doesn't care about the decline of a stock price as long as the firm's competitive advantages remain intact and its cash-flow stream remains robust, dividend growth investors are the same. They do not care if shares of their dividend growth gem fall, as long as the underlying strength of the business is not damaged or the future cash flows that fund the dividend are not impaired. Today's dividend growth investors have become business owners focused on the future free cash flows delivered to them(dividend payments). The stock market might never be the same.

#3. Retirement Goals Have Become Achievable

Today's dividend growth investor is no longer interested in listening to a stock-market guru at an investment bank forecast the expected return on equities over the next few decades. They don't believe in this anymore. Today's dividend growth investor is calculating when their expected dividend yield on cost will be sufficient to generate a nice annual income stream for retirement. They are taking their destiny in their own hands.

Today's dividend growth investor is making use of Valuentum's Dividend Growth portfolio management tool. They are calculating when their investment will double on the basis of the rule of 72 via dividends paid to them. They're laser-focused on the Valuentum Dividend Cushion scores of their dividend growth firms to ensure growing cash flows will continue to come in. They have found a way to achieve their retirement goals without exposing themselves to all of which they have come to distrust in the stock market.

They have found a way to make the stock market work for them. And we applaud today's dividend growth investor!

Enter: The Truth about Dividend Growth Investing

History has revealed that the best performing stocks during the previous decades have been those that shelled out ever-increasing cash to shareholders in the form of dividends. In a recent study, S&P 500 stocks that initiated dividends or grew them over time registered roughly a 9.6% annualized return since 1972 (through 2010), while stocks that did not pay out dividends or cut them performed poorly over the same time period (Source: Ned Davis Research).

But paying a dividend in itself is not a value-creating move by a company, a statement that gets shoved under the rug in the presence of the above data. Investors should understand that a dividend is a transfer of income, not a way that a company generates value for shareholders. Individual investors, financial advisors and even professional money managers love dividend growth investing, but investors should take notice of dividend stock pitches that do not consider capital preservation as a major consideration.

There is a heightened risk, in our view, that sell-side analysts may even stretch valuations in the years ahead to keep high-flying dividend-growth stocks from being excluded as options. Individual investors, financial advisors, and money managers alike should begin to take note of this risk. Having an independent research provider like Valuentum at your fingertips to provide an objective valuation assessment will only become more valuable in the years ahead, if only for a second opinion.

What Are Dividend Growth Investors to Do?

We think a focus on underpriced stocks that have strong dividend growth potential, healthy balance sheets, and solid cash-flow generation is the best way to position for future risks that run the gamut from interest rate spikes to dividend growth investing falling out of favor. These firms generally have both a high Valuentum Buying Index score and a high Valuentum Dividend Cushion score. The following are but three potential ideas from the 15+ holdings in the Dividend Growth portfolio.

Altria (NYSE:MO) - Dividend Cushion: 1.2; Dividend Yield: 5.1%

We continue to prefer Altria on the basis of its hefty annual dividend yield. The company continues to raise the dividend at a nice clip and holds a prized 27% ownership stake in SABMiller, which continues to perform well. SABMiller currently sports a ~R800 billion market capitalization (or about $80 billion USD at current exchange rates), which means Altria is effectively sitting on $21.6 billion in potential cash (about 30% of its market capitalization) at current price levels. We think this hidden asset within Altria's portfolio is the primary difference between our fair value of Altria and its market price. Altria remains a core holding in the portfolios of our Best Ideas Newsletter and Dividend Growth Newsletter. We think Altria's shares are worth $40 each.

Apple (NASDAQ:AAPL) - Dividend Cushion: 2.9; Dividend Yield: 2.3%

We think consensus estimates for Apple's earnings through the middle part of this decade are too low (on the basis of the recent China Mobile transaction), and the company's committed entrance into China bolsters the sustainability of the firm's long-term earnings stream, offering support for our estimate of its cash-flow based intrinsic value. We like the company's track record of innovation and its extremely healthy balance sheet that will pave the way for significant dividend growth and opportunistic share buyback opportunities. We continue to believe Apple's shares are worth north of $600, with upside to over $750 on the basis of the high end of our fair value range.

Microsoft (NASDAQ:MSFT) - Dividend Cushion: 3.3; Dividend Yield: 3.1%

Microsoft continues to be a no-brainer. The firm has robust free cash flow, a rock-solid balance sheet, and significant revenue and earnings growth potential. As we continued to pound the table on shares for much of the past two years-the company is one of the largest weightings in the portfolio of our Dividend Growth Newsletter-others said Microsoft was "dead money" and would continue to be. Though a search for a new CEO has increased uncertainty a bit, the company continues to hover around multi-year highs.

Source: The Unadulterated Truth About Dividend Growth Investing