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Let's say you are sitting on a substantial capital gain in one of your dividend growth holdings in a portfolio meant to deliver an optimum income stream. In an income portfolio, you have to evaluate the capital you have tied up in each holding and periodically determine if you have better options for growing your income by redeploying that capital. I had already begun putting this article together when I read David Van Knapp's interview with SA. In that article he mentions that often a run up in price for a dividend growth holding may lead the investor to consider selling. This can give the investor the opportunity to use those profits to increase total cash flow.

McDonalds

Let's walk through an example from my portfolio. I own 1,040 shares of McDonalds (NYSE:MCD). I have owned these shares since December 2003. My cost basis is $25.50 per share. I think we all know MCD:

McDonald's Corporation, together with its subsidiaries, franchises and operates McDonald's restaurants primarily in the United States, Europe, the Asia Pacific, the Middle East, and Africa. As of December 31, 2011, it operated 33,510 restaurants in 119 countries, including 27,075 franchised restaurants and 6,435 company operated restaurants.

Naturally, I'm quite happy with this 280% gain and happy with the growth in the dividend over the past 8 years. (In this article I will use a lot of data from David Fish's US Dividend Champions spreadsheet.) MCD has a 10 year DGR of 27.4%. In 2003, the dividend per share was $0.40, giving me a yield of 1.65% at the time of purchase. When I bought MCD, my primary motivation was not yield or even dividend growth. At that time, there had been reports of possible Mad Cow Disease contamination in some of McDonalds' hamburger meat. Naturally, this knocked down the share price of MCD. Given that McDonalds had recently begun to revamp their franchise network under their "Plan to Win" strategy, I estimated that the meat scare presented a good entry point for an iconic brand. Since then, the dividend has risen to $2.53 in 2011. Occasionally, I see lots of chatter about "yield on cost" here on Seeking Alpha, but quite simply, a current dividend of $2.53 on a cost per share of $25.50 gives me a YOC of 10%. (I did not reinvest dividends except for a brief period in 2010.)

However, if I take a step back and look at the approximately $100k I have invested in MCD, I wonder if it would make sense to redeploy this capital. Certainly, I can buy a higher yield; the current yield for new money in MCD is 2.6%. And while current yield is not relevant to my cash flow, it may indicate that the stock price has outrun the dividend for now. But I want to have some assurance that any alternative investments will have good prospects for dividend growth and capital growth as well. Let's look at some of the fundamentals for MCD:

Share Price

$96.84

Div

$2.53

Yield

2.61%

NY EPS

$6.32

P/E

15.32

5 Yr. DGR

20.40%

Proj DGR*

15%

Est 5yr EPS GR

9.80%

The Projected DGR is my estimate. The 5 year dividend growth rate of 20.40% includes a 50% increase from 2006 to 2007. The 3 year growth rate is a more modest 15.9%, so I'm expecting a more conservative growth rate going forward. What can I reasonably expect from holding MCD for the next 5 years? I will hold the P/E steady at the current ratio based upon the forward year earnings estimate and the estimated earnings growth rate of 9.8%.

YR1

YR2

YR3

YR4

YR5

Total

EPS

$6.32

$6.94

$7.62

$8.37

$9.19

Stock Price

$96.84

$106.33

$116.75

$128.19

$140.76

$140,755.10

Div Rate

$2.80

$3.22

$3.70

$4.26

$4.90

Tot Div

$2,800.00

$3,220.00

$3,703.00

$4,258.45

$4,897.22

$18,878.67

The above table would project that at the end of 5 years, my stock would be worth $140K, and I would have collected a total of almost $19,000 in dividends for a total return of almost 60%. This is without reinvesting dividends, since I am using the distributions for my income.

Now we turn to the question of whether we can increase the dividend income and improve the total return by selling all or some portion of McDonalds and reallocating these funds into other dividend growth stocks. Let's run through some projections using 2 dividend Champions, Johnson & Johnson (NYSE:JNJ) and Leggett and Platt (NYSE:LEG). Certainly it's not necessary to sell all of the MCD shares, but for argument's sake, let's assume we will do just that and buy equal dollar amounts of the two new stocks. This is not a recommendation to purchase either JNJ or LEG. They are being used here as examples of dividend growth alternatives. Also, in this article I am not dealing with any tax issues related to selling the MCD shares, since this will vary depending upon whether the shares are held in a taxable account, IRA or ROTH, and the investor's individual tax situation.

Johnson & Johnson

From Yahoo Finance:

Johnson & Johnson engages in the research, development, manufacture, and sale of various products in the health care field worldwide. Its Consumer segment offers products for use in the baby care, skin care, oral care, wound care, and women's health fields, as well as nutritional and over-the-counter pharmaceutical products.

Johnson & Johnson is so diverse, owning JNJ is like owning a mutual fund for the health care industry without paying any management fees. Key metrics for JNJ:

Share Price

$64.74

Div

$2.25

Yield

3.48%

NY EPS

$5.43

P/E

11.92

5 Yr. DGR

9.10%

Proj DGR

9.10%

Est 5yr EPS GR

5.80%

Projecting the dividend income and share price using the current P/E of 11.92 and estimated EPS growth rate of 5.8% here's what we might get from holding JNJ for the next 5 years:

YR1

YR2

YR3

YR4

YR5

Total

EPS

$5.43

$5.74

$6.08

$6.43

$6.80

Stock Price

$64.74

$68.49

$72.47

$76.67

$81.12

$62,866.18

Dividend

$2.28

$2.49

$2.71

$2.96

$3.23

Tot. Div.

$1,767.00

$1,927.80

$2,103.23

$2,294.62

$2,503.43

$10,596.07

Leggett & Platt, Inc.

From Yahoo Finance:

Leggett & Platt, Incorporated designs and produces various engineered components and products worldwide.

It's difficult to summarize LEG. It produces a wide variety of components for residential and commercial furniture as well as for the automotive industry. It was incorporated in 1883. Since their business is subject to economic cycles, they could experience accelerated growth going forward. Key metrics for LEG:

Share Price

$22.42

Div

$1.09

Yield

4.86%

NY EPS

$1.60

P/E

14.01

5 Yr. DGR

9.90%

Proj DGR*

8.80%

Est 5yr EPS GR

15.00%

Here I am projecting their dividend growth rate as 8.8% which is their 10 year DGR. The 5 year DGR of 9.9% includes one year with a 42% increase which may not be repeated going forward. Using these metrics, here's what we might get from holding LEG for the next 5 years:

YR1

YR2

YR3

YR4

YR5

Total

EPS

$1.60

$1.84

$2.12

$2.43

$2.80

Stock Price

$22.42

$25.78

$29.65

$34.10

$39.21

$89,130.51

Div Rate

$1.12

$1.22

$1.33

$1.44

$1.57

Tot Div

$2,545.76

$2,769.79

$3,013.53

$3,278.72

$3,567.25

$15,175.04

Summary

If we then summarize the result of the two projections starting with today's $100k, leaving it in MCD or reallocating to a combination of LEG and JNJ, we have the following:

MCD

LEG+JNJ

Value of shares

$140,755.10

$151,996.69

7.99%

Dividends

$18,878.67

$25,771.11

36.51%

Total Return

$159,633.77

$177,767.81

59.63%

77.77%

The key result here is that our dividend income could be higher by a total of 36.5% for the 5 years by swapping our total McDonalds investment into equal dollar amounts of JNJ and LEG. This is not because they are necessarily superior companies but because we were able to leverage our considerable gain in the value of the McDonalds shares for exposure to additional dividend growth streams. Clearly these projections are a function of numbers and estimated growth rates, but that is the nature of investing. For example, if MCD were to sustain a DGR of 30% for the next 5 years, then our dividend income from McDonalds would grow to the same 5 year total as we are projecting for the LEG + JNJ investment. But that is probably not realistic.

We generally like to "let our winners run," but in a dividend growth income portfolio, we may need to consider how to reallocate some of our gains to maximize the income stream.

Disclaimer: Please do your own research prior to making any investment decision. This article is not a recommendation to buy or sell any security and is the opinion of the author.

Source: Cash In Profits From A Dividend Growth Winner To Increase Income