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Summary

  • Income investors have gravitated to dividend growth due to its many attractive characteristics.
  • Valuations and payout ratios have expanded over the past 5-10 years in many widely held DG companies.
  • What is the optimum payout ratio range for a dividend growth company?.
  • Starting yield point, dividend growth rate, and value awareness are key to a successful dividend growth strategy.

In this era of ZIRP, there has been a gravitation towards stocks as an income investment solution. In my estimation, it has been mostly mindful gravitation, since yields available in typical income avenues - bonds, CDs, and other fixed rate securities - are at historically low levels. Retirees and other long-term investors less concerned about growing their capital base are being attracted to the inflation-fighting dividend growth and income stream that generally well-established C-corps are capable of providing.

But this drift to income-equity has been met with considerable skepticism, with many bloggers continuing to slap the tired utterance of "bubble" or "yield chase" moniker on dividend stocks, whether of the high- or low-yield variety. Since most such analysis rarely includes valuation discussion and points more towards the "herd mentality" that's opined to exist, I usually take such criticism with a grain of salt and as majorly knee-jerk, or even uninformed commentary.

Still, there is no denying the fact that mega-cap dividend growth stocks have seen expansion of earnings multiples during the recent 5-year bull run and that dividend growth is seeing heightened retail investor interest. But the stock price expansion that we have witnessed has seemed rather orderly and hardly insane, given the lack of parabolic rises that one might expect during an asset bubble. We see this below in the charts for both a widely held DG stock, Colgate (NYSE:CL), as well as Vanguard's Dividend Appreciation ETF (NYSEARCA:VIG), which holds 163 dividend payers.

Colgate - 5 years VIG - 5 years

So from a valuation perspective, there is certainly added risk to buying dividend growth stocks today versus five years ago, as you are generally getting more expensive companies at lower yield points without accompanying earnings acceleration. Let's take a historical look at Colgate.

Back in 2009, Colgate traded in the mid-30s with an associated 16 multiple, based on core earnings of $2.18 a share. Last year, the toothpaste giant traded in the mid-60s at an almost 23 multiple - 44% expansion. This year, the company is expected to earn roughly $3 a share, again a 23 multiple, on latest trades of $68.50. While other dividend growth stocks don't sport multiples quite as high as Colgate - with CL being one of the most expensive - I think that it's pretty fair to say that dividend growth stocks as a whole are not being looked at as values, given their generally single-digit growth rates.

Source: Colgate.com

To get a collective take on dividend stock valuation, if we examine the characteristics of the aforementioned Vanguard Fund, VIG, we can see that on a blended basis, the fund trades at a 19 multiple to earnings, with an EPS growth rate of roughly 9%. For those fond of quantitative statistics, this works out to a PEG of 2 - which is generally considered quite expensive.

Source: Vanguard.com

But dividend stocks, especially those with a consumer non-cyclical tilt, are prone to be given a premium by the market due to their mature business models and consistent, reliable streams of cash flow. But as the five-year bull run meanders on, I believe it would be a mistake not to view multiple expansion as some sort of risk for dividend growth blue-chips, even if their cash flows - and associated dividend flows - remain uninterrupted.

Payout Ratios

I believe income investors should be paying particular attention to the payout ratio when evaluating the merit of any given dividend stock, but especially those that they are buying for prospective dividend growth. If we refer back to Colgate, over the past ten years, its payout ratio has risen from roughly 40% (.44 dividend on $1.21 of core EPS) to what should be about 48% this year (1.44 dividend on expected $3 EPS).

Source: Colgate.com

Equities with lower payout ratios possess greater ability to raise dividends than those with higher payout ratios. As I explained in a recent article, "Just How Risky is High-Yield Dividend Investing," there are major financial flexibility differences in companies that are paying out 85% of earnings versus those that are paying out 30 percent. Some also argue that the payout ratio should be calculated utilizing free cash flow instead of net income, since it measures the actual amount of available cash that is being distributed. In many cases, that would increase the payout ratio.

So from 2004-2014, while Colgate has increased its dividend payout more than 3-fold, its EPS hasn't risen nearly as much - ergo, the higher payout ratio it now maintains. While not necessarily a troubling statistic, investors should consider the implications of a rising payout ratio as part of their due diligence.

If more earnings - or free cash - is being utilized for dividend payments, the less that is available for other accretive business purposes. Thus, a thoughtful balance of dividend distribution alongside growth initiatives and debt issuance must be maintained by corporations. If the payout ratio grows too high, there may be a lack of capital and/or flexibility to grow earnings, which could inhibit the business and the potential for future dividend growth. If the payout ratio is too low, resulting in a large wad of accumulated cash, the company may be criticized for not accretively utilizing it and/or not paying it out as a dividend.

In addition to the payout ratio, which measures the amount of current operating EPS that is being paid to investors, one should also consider the amount of liquid cash that is sitting on the left side of the balance sheet. Combined, one can get a good idea of forward dividend growth expansion that can occur with any given stock.

What's The "Right" Payout Ratio?

For mature C-corp dividend growth companies, there appears to be a comfort zone of payout today in the 40%-60% range, as we can see in this diversified sampling of widely-held DG stocks.

StockPayout

Colgate

48%

Kimberly Clark (NYSE:KMB)

55%

Chevron (NYSE:CVX)

40%

Coke (NYSE:KO)

58%

General Electric (NYSE:GE)

52%

Johnson & Johnson (NYSE:JNJ)

48%

Procter & Gamble (NYSE:PG)

61%

McDonald's (NYSE:MCD)

56%

Source: Yahoo Finance 2014 estimates/annualized 2014 dividend

From this, we can generally conclude that within the 40-60 range, mature companies are able to effectively operate, pay a dividend in the 2%-4% range - which all of the above do - and retain enough capital to invest in their businesses on a year-in, year-out basis.

For optimum dividend growth "safety," I would opine that a lower dividend payout percentage might be preferred in a purchase, but a lower rate alone does not provide much meaning. The ability to grow the dividend is predicated by EPS and cash flow growth. Over the next decade, if Chevron's EPS growth lags that, say of McDonald's, it may still be able to keep up with Mickey D's dividend growth (assuming it is equal to EPS growth), but it will have to increase its payout ratio to do so.

If a recession or other negative macroeconomic event were to strike, companies with lower payout ratios would be in better position to continue dividend growth, even if their earnings were to flat-line or drop. So I would opine that Chevron - at 40% payout - is in a better position to weather a business downturn than Procter or Coke - which both hover around 60% of payout.

Colgate, which saw its payout ratio rise by nearly 10% over the past decade, won't be able to continue that trend ad infinitum. If its payout ratio continues to rise, eventually EPS will have to catch up to the excess dividend growth provided to shareholders. Still, Colgate would seem to have a bit more flexibility with its dividend policy than say P&G, given its double-digit lower payout ratio. But interestingly enough, PG raised its dividend by more than CL this year - 7% and 5.88%, respectively.

Companies can certainly push payouts past 60% and up to 70% or even higher, but there is a point where fiscal equilibrium will likely become unstable, resulting in additional need for capital. As I mentioned in the high-yield article, most companies with elevated payout ratios are forced to tap equity markets as a strategy to grow their businesses, something most mature C-corps don't do.

Starting Yield Point And Dividend Growth Rates Are Key

For investors preoccupied with maximizing actual dividends received over time, initial yield is certainly a critical data point. Indeed, there are many dividend investors who won't invest in a stock unless a certain yield threshold is met. Of equal importance for the dividend growth investor, however, is the forward dividend growth rate. Let's take the investor who is looking today at both Procter & Gamble and Colgate as potential buys.

Common shares of P&G and Colgate currently yield 3.2 and 2.1%, respectively. Given its lower valuation, our investor might say that P&G represents the better value and dividend idea - and it certainly might today. But if we assume that Colgate is able to provide better average dividend growth over the next decade - which is entirely possible, if not probable - let's hypothetically say 9% versus 6% for PG - which company will produce the most income for investors?

If we do a 10-year yield on cost (YOC) calculation, we find that P&G will generate 5.47% YOC over 10 years with 6% dividend growth, and CL produces only 4.9% yield with 9% growth. Despite the fact we think the dividend will grow faster, Colgate's low initial yield and higher valuation are two tough to overcome obstacles. While I do own shares of Colgate, and have for many years, I do not recommend adding at current levels.

So finding a combination of high initial yield coupled with a reasonably sustainable dividend growth rate would seem an ideal income investing solution. But 5.5% yield on cost may not be sufficient for many investors with lower bases of capital to start with. It might also be considered speculative, since we really have no idea what actual rate of dividend growth will be achieved. History can be a guide, but it is shouldn't be viewed as necessarily predictive.

If perceived yield growth is insufficient to meet income needs, there are certainly alternatives. One can invest in high-yielding equity possessing likely lower dividend growth and potential heightened risk, or in low-yielders or non-yielders with sketchy dividend growth histories that are producing (or might produce) robust, double-digit forward dividend growth. One such low-yielding growth company I've mentioned in the past that I see with considerable dividend growth prospects in Dunkin Brands (NASDAQ:DNKN).

Summarizing Dividend Growth Risk

Since many of the companies that produce dividend growth are household variety names with iconic brands that possess as bulletproof of business models as they come, there would seem to be little risk to most dividend growth companies falling off the face of the earth. Speaking a bit more pessimistically, however, one should probably not summarily view a dividend growth company with an impressive history as a "forever holding." Looking near-term, investors should be extremely cognizant of valuations and whether low entry yield points and speculated payout growth are one's best portfolio solution, as opposed to other higher-yielding or pure growth options in the market.

Indeed, the major risk of exclusive dividend growth investing is that one's anticipated income stream falls short of expectations over time. There's certainly no guarantee that if you budget for 8%-10% dividend increases, especially in stocks with higher payout ratios, that you will necessarily receive them consistently over long time frames. Of course, that risk may be no more than the probability that a growth stock fails to reach a price objective or a higher-yielding stock lowers its dividend.

One other risk, although I suppose it should be viewed more as a penalty or negative consequence as opposed to a risk, is the tax implication of investing in dividend stocks outside a qualified account. The ability to defer tax consequence by investing in non-dividend payers is certainly a benefit for long-term investors not needing an income stream today.

Lastly, I do think the symmetric valuation rise that has occurred in dividend growth names during ZIRP is no coincidence. If and when interest rates rise, resulting in a resurgence of bond and other fixed rate security popularity, valuations of dividend growth stocks will likely drop, resulting in higher yield points. If that occurs sooner than expected, there is certainly capital risk and income opportunity cost associated with buying dividend growth blue chips today at current yield points.

To conclude, though my instinct has always told me that the safest of portfolios includes a mix of different security types and stock picking strategies, if I had sufficient capital base and was forced to select one equity strategy to set and forget for the long term - it would be dividend growth. Like any equity selection strategy, there is risk, but a dividend growth strategy with a value tilt would seem to sit near the bottom of the risk barrel.

Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.

Source: Just How Risky Is Dividend Growth Investing?