Chuck Carnevale's  Instablog

Rightfully, investors are attracted to stocks that pay a dividend and increase it every year.  This is especially true in today’s low interest rate environment. Currently, due to historically low valuations,  many blue chip companies can be purchased with a dividend yield close to what a 10-year treasury bond is paying.

Examine The Choices

Common sense and instincts would suggest that given a choice of two blue chip dividend paying selections, the one with the highest current yield is the better choice. However, we are going to show, utilizing our Fundamentals-at-a-Glance™ research tool, how this is not always the right decision. It is possible, that the lower yielding company will deliver the most dividend income over time, and if true, the best total return as well.
 

McDonalds (MCD), Corp. and H.J. Heinz (HNZ) Company are two well-known dividend paying blue chips. At current values H.J. Heinz (HNZ) offers a dividend yield of over 4% and McDonalds (MCD) yields just over 3%. Since Heinz (HNZ) is paying a higher yield, many would assume that it offers the highest income. Closer examination reveals this only likely to be true over a short period of time. Longer term (5 years or more), we would expect McDonalds (MCD) to deliver the most income.

The Short Run
In Figures 1-4 below, we examine the completed 5-year results for H.J. Heinz (HNZ) and McDonalds (MCD) for calendar years 2004-2008. We are using this time frame to show actual completed results, no forecasts. Therefore, this information is factual.

 

In Figure 1 below, we show the 5-years earnings growth (Green line with white triangles) and illustrate the dividends paid out of the earnings on top of the graph (light blue shaded area). The black line is the monthly closing stock price over the five years and clearly tracks earnings. Note that H.J. Heinz (HNZ) grew earnings at a compounded rate of 4.8% over the five years (red circle). Click on the words “short video” at the top of the graphs for an audio explanation of the graph.

Figure 2 below is a performance table for H.J. Heinz (HNZ) that corresponds to Figure 1. Note that H.J. Heinz (HNZ) dividends increased from a $1.14 per share in 2004 to $1.66 per share in 2008. Cumulative total dividends equaled $18,995.40 and are assumed spent, not reinvested. A $100,000 investment appreciated by only six tenths of one percent (0.6%) due to undervaluation at 2008 year-end, and therefore only grew to $103,212. Total return was 4.1% including dividends. Click on the words “short video” at the top of the graphs for an audio explanation of the table.

In Figures 3 & 4 below we repeat the same information for McDonalds (MCD). Figure 3 depicts that McDonalds (MCD) grew earnings at 20.7% compounded annually (purple circle) a much faster rate than Heinz (HNZ). Once again, note how stock prices (black line) closely tracked earnings (green line with white triangles) over the time period. Click on words “short video” at the top of the graphs for an audio explanation of the table.

 

Figure 4 shows that even though McDonalds (MCD) started the period with a lower yield, their dividend grew much faster due to their much faster rate of change of earnings growth. Therefore, the total dividend income of $21,504.18 was more than H.J. Heinz (HNZ) shareholders received over the same 5-year period. So even though McDonalds (MCD) started the period with a lower yield, their shareholders received more total income over the period. Therefore, less dividends became more dividends. Most importantly, the shareholders of McDonalds (MCD) also benefited from capital appreciation of 20.1% that correlated almost identically to their earnings growth rate.

Fig. 4. MCD 2004-2008 Dividend and Price Performance (see short video) 

The Long Run
Figures 5-8 validates the thesis over an expanded time frame of 20 years to current and includes forecasts. Clearly, the same principles apply. Approximately 20 years ago, McDonalds starts with a lower beginning yield, but thanks to much faster growth ends up generating more dividend income and total return for its shareholders.

In the long run, shareholder returns will be a function of the income stream the company generates through earnings. Both capital appreciation and dividend income will be driven by earnings. Of course, dividends represent a portion of earnings paid out called the payout ratio. Companies tend to be very consistent with their payout ratios.  Also, as a general rule, more mature slower growing companies tend to have a higher payout ratio, and faster growers lower ones. If current income is needed, then the higher yield may be the best choice. However, if total return and/or longer range income needs are required you should opt for the fastest grower. McDonalds is the clear long-term winner over H.J. Heinz (HNZ) for both dividend income and capital appreciation.
 

Full Disclose: long MCD at time of writing.