Visa (NYSE:V) has proven to be an exceptional company in the last eight years or so. Back in 2008 the company was earning just under 60 cents per share. Now the company makes over four times that, equating to an annualized average compound growth rate of about 25%. This robust EPS growth has been fueled by strong top line growth, greatly improved margins and a solid reduction in the share count. Add to this the idea that the company has clear growth prospects, carries no debt and has a solid balance sheet, and it's easy to see why partnering with the business would be compelling.
Despite all of the positives, there are a couple of negatives for some investors: 1) an above average valuation and 2) a low dividend yield. I think addressing each can give you a better feel for the process.
First you have the idea that superior growth can warrant a loftier valuation. Analysts are presently expecting the company to grow by 15% or more per year over the intermediate-term. Let's scale that back and call it 10% annually. If Visa were to grow earnings-per-share by 10% per year for the next decade and trade with a P/E ratio of 18, this would equate to a future share price of about $120.
Expressed differently, you could see 5% to 6% yearly share price appreciation even with a lower growth rate and a greatly reduced earnings multiple. And that's prior to considering the dividend. Faster growing companies can "grow out of" higher valuations much easier than their slower growing counterparts.
The second part is that a lot of people recognize the quality of the business, but get turned off by the low dividend yield. Visa presently pays a $0.14 quarterly dividend which works out to a "current" yield of about 0.8%. Even with substantial expected growth it's hard to get excited about a yield under 1%.
As a result of this, a lot of investors take a pass, they say, "great company, low yield, I want income, what's next?" Yet I would contend that this mindset is not taking advantage of all of the tools in your toolkit. Or at the very least it's not being aware of all the options available. You can both own shares and generate a greater cash flow than the dividend alone. For instance, you could elect to own shares and sell a covered call.
Here's an example: the January 20th 2017 call option with an $82.50 strike presently has a bid of about $2.90 - call it $2.65 to deal with transaction costs and fluctuations. If you owned 100 shares of Visa you could make this agreement. You would be agreeing to sell your shares at a price of $82.50 anytime in the next year. For offering this option, you would receive $265 in upfront premium income (which is potentially taxable at ordinary rates).
The cash coming in from owning Visa suddenly went from ~$60 to $265 or more. Your yield suddenly jumps up to 4% - well in line with other dividend growth companies that might otherwise catch your attention.
Now there are two basic outcomes involved with making this agreement: either the option is exercised or it is not. Let's see what happens if the option is not exercised. In this situation it's exactly the same as owning shares of Visa, with the added benefit of receiving the upfront premium. You'd get ~$265 upfront along with ~$60+ in dividend income. Your total cash flow would be about $325, good for a pre-tax yield of about 4.7%.
A lot of people like to point out that the option premium may not offset the volatility of the share price. That is, selling a covered call does not prevent you from seeing a negative total return. Yet I would contend that ideology is largely "trader" or "short-term" based. In this instance, I'm specifically referring to shares that you plan to hold onto anyway.
The second possibility is that the option is exercised, requiring you to sell your shares at the agreed strike price, in this case $82.50. This would most likely occur with a share price above $82.50. In this scenario you have "capped" your gain. You would "only" receive the upfront premium of ~$265, the sale price of $8,250 and any dividend payments along the way. If the share price rose up to $120, you're stuck selling at $82.50. This is why it's important to only make agreements where you're happy with either outcome.
Capping your gains is indeed a risk, but I'd contend not an especially troublesome one. In this particular case if the option were exercised, a $6,900 starting investment would generate between $8,500 and $8,600 depending on if you received dividends and transaction costs. That's agreeing to a 23% gain over the year-long period. Give me that return each year and I'll show you a way to quickly build wealth.
In sum, selling a covered call does not prevent against loss and it can cap your investment gain. Both sound like bad news, but really it's a matter of deciding whether you're happy with a given agreement. If you're content to own shares of Visa in the next year regardless of the share price, the covered call provides more upfront income. If you're happy with a 23% return, the "risk" of losing out on a potential 30% gain isn't as apparent - someone else will always be getting richer faster.
The upside to this awareness is that you can look at low yielding securities with a bit more interest. A company like Visa might strike you as an exceptional business, but the low yield could prevent you from digging deeper. With options at your disposal you can both own a lower yielding security and simultaneously generate a solid cash flow stream.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.