In the course of my articles, I'll often state things such as the following: "if these estimates come to fruition, this could indicate annual total returns of 10% over the next half decade." Yet what I usually leave out is the underlying math involved. I assume either comprehension or trust. For this commentary, I'd like to work with the mechanics a bit. For many I'd imagine this might be a review; however, if this article can help even a handful of readers out there, then surely it'll be worth it.
"Mickey D's has increased its dividend for 38 consecutive years and has a "current" yield of about 3.4%. With a 7.4% expected dividend growth rate, this could indicate that an investor would receive 21% of their initial investment back in the form of dividends. Return expectations for a future dividend yield in the 3% to 4% range would fluctuate between 7% and 13%."
I cut to the punch line -- McDonald's could return 7% to 13% in the intermediate-term -- without demonstrating the assumptions. What follows is the backend to those types of suppositions.
Basically you have two types of investigations: high-level and in-depth. The in-depth one ordinarily takes hours upon hours and varies from physically checking out subsidiaries to making hundreds of adjustments in the financial statements. That's a full time job and well beyond the scope of this article. Nonetheless the high-level view, which I'll call "valuation shortcuts," can give you a pretty good idea of whether or not the company is worthy of further research in just minutes.
I like to use three shortcuts. The first is an equation:
Payout ratio = P/E ratio * Dividend Yield
It works because you're saying: Dividend / Earnings = Price / Earnings * Dividend / Price. The price on the bottom and top cancel out, and you're left with an equal equation. If you give me two of the variables, I can calculate the third. For instance, if you told me that McDonald's paid out 59% of its earnings and had a 3.4% dividend yield; I would know that the P/E ratio must be just over 17.
So anytime I read or hear a combination of the above, I automatically calculate the third variable. Take a company that pays out 50% of its profits and has a P/E ratio of 20. Now you know it also has a dividend yield of 2.5%. It might seem like an unimportant observation, but really it has instant practicality.
For instance, think about Wal-Mart (NYSE:WMT). If you know it's been trading around 15 times earnings with a 2.5% dividend yield, you would also realize that the company is paying out less than half of its profits in the form of a dividend (about 38%). Sequentially, you might imagine that Wal-Mart has the ability to grow dividends faster than earnings in the intermediate term or else buy back shares each year. Likewise, this is the same reason why the Dividend Champions tend to trade at premium valuations -- the companies simply pay out a large portion of profits.
You have all this insight in just a few seconds of observation. Of course, you then have to confirm that the given numbers don't have one-time events, special dividends or any anomalies. Yet it's easy to see that a high-level look at a company's P/E, yield and / or payout ratio can reveal some information quickly.
The second and third shortcuts take a bit more time, but are equally important. When considering different partnership opportunities, I like to think about what the future multiple and yield construct of the company's shares might look like. In doing so I often default to a 5-year time horizon for consistency. However, it should be underscored that this is mostly due to available observations (the further away you get, the more clouded your view becomes). In reality, I wouldn't partner with any company if I didn't fully expect to own a piece of the business in the decades to come.
To start, you need to take stock of where you are presently. Continuing with our illustration, McDonald's earned just over $5.50 last year and will pay $3.24 in dividends. With a current price around $94, this equates to the aforementioned 59% payout ratio, 3.4% dividend yield and P/E around 17. That's the starting point.
Next, you're forced to make some assumptions. Using an in-depth analysis, you would project and scrutinize over nearly every metric. However, the high-level view only needs two variables: future earnings and future dividends. We'll start with earnings. Keeping it high-level, McDonald's is expected to earn roughly the same amount this year as it did last year and perhaps $6 per share next year. After that, the expectation from various sources is around 8% yearly growth. This would equate to earnings-per-share of just over $8 in 5 years' time. In the sake of conservatism, you may suggest $7.50 is achievable.
On the dividend front, you might image that the payout ratio would remain fairly constant. As such, 6% annual dividend growth could be used as a baseline. Here's what that would look like:
2015 = $3.43
2016 = $3.64
2017 = $3.86
2018 = $4.09
2019 = $4.34
In total, this would suggest that an investor could collect about $19 in dividend payments over a 5-year time period (really it might be closer to $20 if you count the payments in 2014, but remember we're keeping it simple). This would mean that today's investor could collect about 20% of their initial investment in the form of dividends over the next half-decade. Certainly this number could be higher or lower, but for a baseline we'll assume every $100 investment turns out $20 in dividend payments over the next 5 years.
After the income component, you need to come up with an end price. As mentioned, there are two very high-level ways of doing this: using an expected P/E ratio or an anticipated dividend yield.
Since 2000, per S&P Capital IQ, McDonald's has had a "normal" P/E ratio around 18. Further, shares have traded at a multiple of anywhere from 12 times earnings to nearly 30 times. However, for the majority of this time, shares have fluctuated in the 15 to 19 range. Given today's multiple around 17, you might believe this is reasonable. Yet for the sake of being conservative, perhaps you use 16. If you take 16 and multiply it by the $7.50 in expected year 5 earnings, you get to a price point of $120. Add in the $19 in dividends and we're at $139 in total expected value. Said differently, shares of McDonald's would have an expected compound total return of 8% per year, given your assumptions (($139/$94)^(1/5)-1). Of course a higher P/E ratio increases the total return expectations.
Interestingly, McDonald's began this millennium with a dividend yield of just 0.5% -- nearly 3 percentage points below where it stands today. Perhaps more attention grabbing is the idea that today's yield represents the highest it's been -- save for possibly a few months during the depths of the last recession. As such, you might imagine that 0.5% to 3.5% is a reasonable dividend range. Although I would contend that you should logically assume a skew towards the higher end of that spectrum.
Using an anticipated $4.34 dividend in 2019, a 3.5% yield, for instance, would indicate a price of $124 ($4.24/.035) for total return expectations approaching 9%. A 3% presumed future dividend yield would indicate total expected returns on the magnitude of nearly 12% per year, which would increase if the dividend grew a little faster.
In sum, if you believe McDonald's is able to grow its earnings or dividends in the manner described above, this could indicate total expected returns in the 7% to 13% annual range. Yet that's not exactly the takeaway.
There are a variety of important notes to be made known. Using anticipated P/E ratios and dividend yields are certainly useful for generating a quick, high-level guesstimate for expected total returns. However, much like the first shortcut equation, they are useful for thinking about the situation as well. For instance, if you believe McDonald's can earn $7.50 per share in 5 years, this would require a 12.5 P/E ratio in order for the price to remain stagnant. If you believe MCD will be paying out $4.34 in dividends, this would require a 4.6% dividend yield at the same price. Certainly either is possible, but it doesn't appear altogether likely. (As such, price appreciation tends to formulate whether your pay attention to it or not.)
A second note is that while a precise number is given -- a $124 share price or 8.13% annual returns for instance -- it's definitely not exact. You're developing a range of possibilities and doing so in quick order. Further, this range of possibilities shouldn't be thought about in isolation. You should take these numbers and compare them to your next, say 50 alternatives.
Finally, you always want to be prudent in your observations. McDonald's could very well trade at 25 or 30 times earnings in the future, but making an investment decision based on that assumption doesn't appear to be altogether cautious. You might miss out on a few Chipotle (NYSE:CMG) type investments by following this approach, but you're likely to avoid some unnecessary angst as well.
You always want to do further research -- investigation that goes well beyond the view in this article. However, I would simultaneously recommend that you look at these shortcuts first. Once internalized, you can complete all three in a few minutes (or seconds) and see if the extra effort is truly worth it. If you need a company to have a 20+ P/E to justify a 5% annualized return, you might just take a pass. You lost 2 minutes discovering this, but at least you didn't spend hours figuring out the pension liability and whether or not management has fulfilled its past promises and that sort of thing. Then, when you come across a McDonald's, you can say: "hey, using somewhat conservative numbers, MCD might be able to generate 7% to 13% annual returns moving forward. Let's go ahead and dig deeper to see if I believe those numbers."
Disclosure: The author is long MCD, WMT.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.