When A Higher Yield Leads To Lower Income

 |  Includes: ED, MCD, V
by: Eli Inkrot


In 2002, McDonald’s had a 1.5% dividend yield as compared to Consolidated Edison’s 5.2% mark.

As such, it might appear that Consolidated Edison had an overwhelming income advantage.

This article looks at this “advantage” and provides a cautionary tale for automatically favoring higher yields.

Today I'd like to highlight an ideology using Consolidated Edison (NYSE:ED) and McDonald's (NYSE:MCD) as illustrations. The title of this article effectively gives away the punch line, so I'll cut to the underlying logic.

By 2002, McDonald's had been increasing its dividend for 26 straight years. Consolidated Edison had a consecutive increase mark of 28 years. So it would be fair to suggest that both companies had a propensity to continuously reward shareholders.

At the end of 2002, McDonald's had a "current" yield of 1.5%, while Consolidated Edison had a yield close to 5.2%. Thus on a forward-looking income basis, it appears that the New-York based utility has an overwhelming advantage.

Indeed, in order for McDonald's to "win" on an income basis today, the company would have had to increase its dividend by an average compound rate of nearly 21% just to match a stagnant 5.2% yield (something unlikely in its own right). Considering that McDonald's "only" grew its dividend by 9% per year in the 1993 to 2002 stretch, this would certainly have been a tall order.

Plus, the outcome isn't even obvious on a historical basis. Here's a table showing the year-end dividend yields for the two companies dating back to 2002.


MCD Yield

ED Yield








































Click to enlarge

There wasn't a single year in which you could have bought McDonald's with a higher starting yield than Consolidated Edison. Yet what is missed in all of this is the idea of growth.

Consolidated Edison grew its dividend from $2.22 in 2002 to today's mark of $2.52 -- a compound rate of just over 1% annually. Consequentially, given the slight fluctuation in yield over this period, the share price moved just slightly as well -- returning about two and a half percent per annum.

Meanwhile, McDonald's grew its dividend from $0.235 in 2002 to today's mark of $3.24 -- a compound rate of about 25%. During this time the dividend yield has also grown at a reasonably quick rate, but certainly not as fast as the share price -- turning in price appreciation on the magnitude of 16% annually.

So we know the punch line: McDonald's needed 20%+ dividend growth to be competitive on an income basis over the last 12 years and it has accomplished just that. But how bad (or good) was it?

If you bought one share of Consolidated Edison at the start of 2003 for $43, you would have received $28.28 back in the form of dividend payments -- representing 66% of your initial capital. Expressed differently, your dividend payments would have provided a 4.4% annualized return on their own. Roughly on par with the dividend yield.

If you bought one share of McDonald's at the start of 2003 for $16, you would have received $21.81 back in the form of dividend payments -- representing 135% of your initial capital invested. Expressed differently, your dividend payments would have provided a 7.6% compound yearly return on their own. This isn't necessarily intuitive, considering the "current" dividend yield never approached this level.

Had you asked investors which company might return more dividend income over the next 12 years, I believe the overwhelmingly favorite would have been Consolidated Edison. Both had increase histories, but ED was paying out three and a half times more income and it would have required McDonald's to grow its dividend by over 20% per annum on average. Yet McDonald's delivered. In the end, you would have received double the income by holding McDonald's -- not to mention substantially more capital appreciation.

Granted, I picked this example on purpose -- I thought it might work out in McDonald's favor. However, that's not the takeaway. I didn't truly want to demonstrate that McDonald's has delivered substantial income via a combination of business growth and an expansion of the company's payout ratio. Instead, I want you to be conscious of high growth rates -- in both dividend and share price -- masking the effects of solid income streams.

If you looked at McDonald's yield in 2002 (1.5%) and then again in 2011 (2.5%), you might imagine that you didn't miss a whole lot. Over those 8 years, perhaps the dividend yield hovered around 2% and an investor may have received back 16% of their initial capital in the form of dividend payments, you might think. In reality, the investor of 2002 would have received nearly 80% of their capital back by 2011, along with over 6 times their initial investment in the form of capital appreciation. When we see a constant or low dividend yield, the mind automatically thinks "slow and steady." Yet that's not the only possibility. The dividend yield could be constant or "low" due to a high dividend growth rate coupled with high share price growth.

Today, something like Visa (NYSE:V) fits into this thesis well. Consolidated Edison has a 4.4% dividend yield as compared to Visa's 0.75% mark. On this basis alone, much like the McDonald's example, it would appear that ED is an overwhelmingly income favorite. Yet again, this misses the idea of solid growth and payout expansion.

In order for Visa to provide more income than Consolidated Edison in the next say 15 years, this would require an average compound dividend growth rate topping 23% -- a seemingly huge number. Yet it might be slightly easier to formulate than it seems. Due to Visa's low payout ratio, the company could have room to expand from paying today's 18% of profits to tomorrow's 50%. If that happens, the company would need to grow earnings by about 15% annually to match Consolidated Edison's total income collected; quite lofty, but below intermediate expectations. Moving forward, the Visa investment would provide substantially higher payouts, all the while perhaps never having a higher starting yield.

Of course, you would also have to consider the benefits of reinvesting the larger Consolidated Edison income stream to begin. However, it stands that if Visa could come anywhere close to generating that type of earnings or dividend growth, the capital appreciation would likely trounce that of Consolidated Edison's.

In the end, I'm not suggesting that Visa will definitely provide more income. I'm simply indicating that it's a possibility. The idea is that a lower yield -- which always remains a lower yield -- could provide more income. The reason is due to high dividend growth being paired with commensurate share price appreciation. The consistent low yield hides the income possibilities from the un-careful eye.

Finally, while the results of the Visa/ED matchup might not be known for a decade or two, our beginning example is actually a solid place to end. McDonald's presently yields about 3.4% versus Consolidated Edison's 4.4% yield. McDonald's may never trade with a 4.4% yield. Yet in just 5-6 years, MCD could provide more income, consequentially reaping higher dividends and greater capital appreciation. Beginning yield is nice to look at, but it means little without context. In evaluating "lower" yield dividend growth options, be conscious of the idea that fast share price growth -- both historically and on a forward basis -- could mask solid income prospects. A higher yield does not automatically necessitate more income.

Disclosure: The author is long MCD.

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.