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There are many investing routes that will lead investors to the goal of financial self-sufficiency. While some try and discover the next high-growth Apple stock, others will gravitate towards boring deep value companies for slow and steady capital growth. A third category is the income investor. With historically low bond yields and rock bottom interest rates, is it still prudent to build up dividend yields?

Income Investing In Stocks Still Makes Sense

Many financial advisors are quick to point out that stock dividends are not the same as bonds. While this is true, these two products do share some similarities.

  1. If you sell your bonds before maturation, you could potentially get less than you put into it if bond prices dropped. The same can be said if you sell your equity shares when prices are less than your entry.
  2. Bonds have risk of default and shares have the risk of a cut dividend or falling company profits, which will lead to a reduced dividend.
  3. Both require some element of timing...I would not recommend buying long-term bonds at rates that cannot exceed inflation, and I would not recommend buying an income stock with poor valuations that cannot support a healthy and growing dividend.

Due to the low yields in bonds and the ability to strategize with stocks, I feel that being an income investor in stocks is the right choice in this low-growth environment. A lack of high-growth opportunities for companies should see an increase in dividend payouts. Dividend payments are the one time where there is a dollar-for-dollar cross-over between share prices and company fundamentals.

How can you strategize with income investing?

Income Investing Strategy

A new wave of income investing has caught on called Dividend Growth Investing. While every Dividend Growth investor has his own take on this strategy, the guiding principle is to find stocks with annual dividend increases (dividends are re-invested).

I've read many dividend growth articles on Seeking Alpha, examined the accompanying charts, and followed the compounding dividend logic they propose. But should you show a preference for big dividend growth or a bigger yield? What about payout ratios? How might share price valuation affect your ability to compound growth?

Dividends, Payout Ratios, and Income Growth rates

To understand the impact that dividend growth rates may have on your portfolio, we need to isolate dividend policy from the company. This is no easy task. Those in support of dividend growth investing may point to successful stocks that have followed such a policy of annual dividend increases.

  • But how much gain was from the successful company and how much from the dividend policy of raising the income annually?
  • Might the investor have made more money if the company just sat on the cash?
  • What if they offered huge payout ratios right away and smaller annual dividend growth numbers versus a small payout ratio and the ability to offer huge dividend growth (for a while)?

These questions need to be asked, since is it simply a matter of good companies adopting this annual dividend increase policy, or is the policy itself somehow responsible for superior gains? Let's create a company to see what effect some various iterations of the dividend policy could have. We will manipulate the following:

  1. Dividend growth rates
  2. Payout ratios
  3. Methods to value share price (based on dividends and based on earnings)

The actual company fundamentals will remain static.

Company ABC

Company ABC has earnings growth of 5% per year and continues to have this into perpetuity. Here are some assumptions we will make for this test:

  1. Any profit not paid out as a dividend (payout ratios less than 100%) will be accumulated as cash
  2. Company ABC will determine its own dividend growth rate, which it can manage until payout ratio reaches 100%
  3. When payout ratio reaches 100%, any excess cash is given as a one-time special dividend payment
  4. Following this, dividend growth rate must match EPS growth rate
  5. We do this test from year 0 to year 40 (which is actually 41 years)
  6. We start investing with $100,000

Our first test will be to run various scenarios using a constant yield valuation.

Dividend Growth and Constant Yield

Under this battery of tests, we will value shares based on dividend yield. This may not be the best method, but really, there is no one agreed upon system for valuing a firm. Our crude valuation technique will use a 20x multiplier on the dividend, plus we need to add in the value of any cash per share that is accumulated. Later, we will use another valuation system based on earnings.

We start at year 0 with a 25% payout ratio. We re-invest the dividends. We will run this test three times, each time starting with a different dividend growth rate. Remember that our earnings are only growing at a constant rate of 5%, and this never changes. We are only concerned about managing our dividend, which has no effect on company fundamentals.

(click images to enlarge)

Next, we will run the identical tests using a valuation model based on a 10 multiplier on earnings while adding in the value of any cash accumulated by the company.

Dividend Growth and Earnings Based Valuation

Applying Basic Model to GE

What sort of 20 year return might we expect if we apply the above valuation technique to GE?

Some assumptions we will make about General Electric (NYSE:GE) are as follows: constant payout ratio of 57.4%, constant EPS growth of 10%, dividend growth that matches EPS growth, underlying PE of 12 once cash per share is removed, and $100,000 invested.

In this case, we could expect to earn a total of $1,040,190 in 20 years with a $34,139.58 annual income stream, which is a 12.42% CAGR.

We can run the following scenario for Microsoft (NASDAQ:MSFT). We will assume a higher 40% payout ratio and use diluted earnings as our starting point. Earnings growth and dividend growth will be a constant 7%, with underlying PE working out to 11.63 once cash per share is removed.

Our 20 year return is $690,039 (this includes the annual dividend payout), and the annual dividend is $14,019.

Of course, there are so many "'what if"' scenarios that can make this a much different picture. But this gives us a good idea if we are going way off course, either through unexpectedly low earnings growth, sky-rocketing P/E ratios, if cash is re-invested with unexpected rates of return or a big drop in payout ratios. As well, companies will likely not accumulate this much cash -- and I can expand on this model to include incremental growth of re-investment -- but this simple excel sheet drives home the point for the average retail investor. It gives the rough outline of a plan so that you can monitor your holdings to see if you are somewhat on the course, or if you need an engine overhaul.

Drawing Some Conclusions

We can see some trends developing here. First and most importantly, we absolutely must consider valuation of a company. A company could have high earnings growth and a superior dividend policy, but if the valuations are off, you could make a higher total return with a far inferior company. You must consider at what price the company is being valued. Certain models like Hyper-Compounding Income take advantage of dividend growth and valuation timing -- which will be discussed in a future SA article. At all times, it is advantageous to look at your P/E ratios, since total profit shows total potential for a future dividend. If your P/E ratio is high, you will have poor re-investment power regardless of your yield. In fact, that is why the low payout ratio works in the first valuation model…because it created deep value share prices for a better re-investment.

Second, as a general rule, you do not want the company sitting on the cash. The hoarding of cash harms the investor, even if this is factored into the share price. By holding the cash, they are denying you the right to compound that equity into the share price. And remember that the share price drops by the value of the dividend, thus giving you a better price to buy at. This is particularly noticeable when the one-time special dividend is given. In general, this means that you should be getting the highest payout ratio possible -- if they retain some for CAPEX that is fine, but no sitting on cash just to manage dividends. Remember though, a high payout ratio is meaningless if the stock is overvalued as described in the above paragraph. You want deep value and the highest payout ratio possible (to include all cash that is just "sitting around" and not being re-invested anytime soon).

Third, if they are sitting on cash and managing the dividend, then you want the highest possible dividend growth rate so they put that money back into your account ASAP. The disparity is largest in the lower payout ratio scenarios.

While we do not yet have a formula to show us which companies will be the best long-term performers, we can rely on valuation, maximum dividend and possible payout ratio, and dividend growth rates to make sure we get the most compounding possible in what our stocks earn today.

Source: Which Dividend Policy Compounds The Fastest?