Bond investors commit to investing their money for a certain period of time in exchange for fixed interest payments. Investors in stocks may receive a dividend payment, but are often more interested in capital gains. Although some financial advisors have recently advised replacing some bonds with dividend paying stocks in income portfolios, I believe that many more people would benefit from this substitution. This is especially true in today’s low-interest rate environment, when bonds almost have to face the headwind of rising interest rates in the years to come.
Pfizer is an excellent example of a well-run company with a nice dividend, plenty of cash flow to cover that dividend, and is growing the dividend. Many investors with a focus on dividends will not consider Pfizer because it cut its dividend in half in 2009 following its acquisition of Wyeth. Although the rate was cut from 32 cents per share per quarter to 16, Pfizer has since increased its dividend twice, to 18 cents per share for February 2010, and to its current 20 cents per share for February 2011. This dividend represents about 36% of its estimated 2011 operating earnings, showing that the dividend is well covered. Although Pfizer cut its dividend to conserve cash for its Wyeth purchase, it has shown a commitment to growing the current dividend similar to its dividend growth from 36 cents per share per year in 2000 to $1.28 per share in 2008.
Pfizer’s current dividend yield is 4.0%; this falls between the 10-year Treasury yield of 3.33% and the 10-year Pfizer bonds yielding 4.79%. However, the tremendous advantage of owning a stock for income purposes is that stock dividends increase, whereas bond interest payments do not (exceptions exist, such as step-up bonds). To accurately value the income stream, we must estimate future dividend increases.
In a first, reasonable outlook, we’ll assume that Pfizer increases its dividend 10% each year for the next three years. This would result in a dividend of $1.06 per share in 2014. After that, we’ll assume that Pfizer cannot increase its dividend as fast as inflation, and instead can increase it merely 2% annually. I think a discount rate of 6% is reasonable; this is more than a 28-year Pfizer bond, and is about what a hypothetical 100 year Pfizer bond would yield if it existed [and the difference between Pfizer and Coca-Cola (NYSE:KO) bond yields held out to that length of time]. A calculated fair value for Pfizer stock in this case is $23 per share.
A slightly more optimistic, and in my opinion more realistic outlook might be that Pfizer increases its dividend 10% each year for 5 years, this would merely restore its dividend to 2009 levels. After that, if we assume Pfizer can increase its dividend 2% annually, and using the same 6% discount rate above, a calculated fair value for Pfizer is $29 per share.
A much more optimistic view might be that Pfizer increases its dividend at a 15% rate for the next 5 years (which would still represent 73% of its operating earnings – high, but doable), and 2% annually afterwards. If you combine this with a discount rate of 5.5% (about equal to Pfizer’s bond maturing 28 years from now), you would come up with a fair value of $37 per share.
In a conservative (some might say pessimistic) case, assuming no dividend increases and a demand of a 7% annual return, a fair value for Pfizer would be a mere $11.43. In my view this is easily much more pessimistic than any of the above projections are optimistic, and represents a reasonable floor for Pfizer stock treated as an income investment. It is worth noting that Pfizer shares never fell this low in the depths of the 2009 crash, the lowest price reached then was $11.66.
It is important to remember what these calculated fair values represent. They are the price at which the value of the dividends of the stock equal the value of the interest payments from the bonds, with the appropriate discount rate applied to each dividend or interest payment. Thus, if one were to buy Pfizer at $23, and the dividend increased as in the first "reasonable " scenario, the value of dividends received would over a long period of time be the same as buying a bond with a 6% coupon rate.
This analysis is thus useful in comparing Pfizer stock to bonds, to determine which would be a better income investment over the long term. By applying what you consider to be a reasonable estimate of Pfizer’s rate of dividend increases, you can calculate a value at which to buy the stock to receive a given level of income.
Additionally, this analysis can be used in the opposite direction. Using the current stock price of $20 per share and the "more realistic " scenario given above (an annual dividend increase of 10% for 5 years, followed by 2% annual increases), gives a discount rate of 7.75%. In other words, the income received over the long term from Pfizer in this situation is the same as a long-term bond yielding 7.75%. That return piques my interest.
Disclosure: I am long PFE.