Coca-Cola With A 4% Yield

| About: The Coca-Cola (KO)

Summary

Coca-Cola has shown an exceptionally consistent dividend history over the years.

Shares have rarely traded with a 4% starting dividend yield.

This article demonstrates two ways to potentially reach this mark.

If you were making a movie about dividend growth, I'd bet a company like Coca-Cola (NYSE:KO) would get a starring role. Naturally history does not dictate the future, but in this arena it is certainly worthy of a mention. The company has paid a dividend dating back to 1920 and has not only paid but also increased this payout for 54 consecutive years, with the most recent boost coming in at just over 6%.

What's interesting about the payout record is that it hasn't exactly been a bumpy or worrisome process. Every year from 1999 through 2016 the annual dividend has been increased somewhere between 5.9% and 13.6%. That's not a lot of variance. The underlying earnings of the company and share price have bounced around quite a bit, but the dividend has been the model of consistency.

Aside from the great consistency, reviewing the history of a security like Coca-Cola can provide insights in other areas as well. Throughout the past two decades or so shares of Coca-Cola had routinely traded with a dividend yield in the 1% to 3.5% range. There was a brief moment during the throes of the recession where you could have owned the security with a slightly higher yield, but basically something in the 2% to 3% had been fairly typical.

Yet just because a security's yield remains fairly constant, this does not simultaneously indicate that an investment has been stagnant as well. In fact, it actually propels the return.

Back at the end of 2004 shares of Coca-Cola could have been purchased with a yield around 2.4%. Today's per share dividend is now 180% higher; meaning that an investor's yield-on-cost would be about 6.7%. Of course Coca-Cola doesn't trade with a 6.7% yield (or 6% or 5% or 4% yield for that matter). As such, the share price must be quite a bit higher as well. Indeed, shares of Coca-Cola trade about 110% higher today as compared to the end of 2004.

Due to that pesky rising share price, the yield remained in a fairly tight range while the dividend just kept on growing. Incidentally, this is why a great deal of income investors insists on forcing on income production and not everyday share prices. If you hold shares of Coca-Cola long enough, as an example, eventually you'll either have a 6% yielding security (let's buy more) or else the share price will eventually catch up.

In short, if you wanted to own Coca-Cola with a 4% dividend yield it might be difficult to do so by simply buying shares. For one, getting that entry point has historically been quite unlikely. Perhaps just as noteworthy, the share price has tended to increase through time to prevent this yield from occurring.

Getting to a 4% yield-on-cost requires time, getting to a 4% "current" yield becomes much less likely. However, that doesn't mean it is impossible. There are two ways that you could think about owning (or potentially owning) shares of Coca-Cola with that sort of income production.

The first is to simply agree to buy shares with a 4% yield. The current quarterly dividend sits at $0.35, or $1.40 on an annual basis. Based on a share price around $44 that equates to a "current" yield of about 3.2%. If you wanted this to be a 4% starting yield you would need to own shares at $35.

This agreement does exist. You could choose to sell the January 2017 put option with a $35 strike price. This means that you would be agreeing to buy 100 shares of Coca-Cola at $35 per share anytime between now and January of next year. In order to "cash secure" the potential transaction you would have to set aside $3,500. By making this agreement you might receive ~$60 or so in upfront premium (which can be taxed differently than dividend income).

Now one of two things occurs: either the option is exercised or it is not. If the option is exercised, your cost basis is below $35 (~$34.40). That represents a 22% discount to today's price and starting yield above 4%. If you want to own shares of Coca-Cola with a 4% starting yield, naturally this could be a favorable result.

If the option goes unexercised you would not purchase shares. In this case you keep your premium and get back your $3,500 in cash to deploy once more. Your total gain would be just 1.7% or thereabouts. This could be a large risk. Yes your return is positive, and indeed better than a CD or savings account, but the opportunity cost could be huge. Should shares of Coca-Cola increase 20% you would have been much better off simply buying shares, despite a starting yield a bit lower than you might have preferred.

To combat this you have a few other options. Instead of selling the $35 put option, you could sell something closer to the current strike price. For instance the last $40 put option expiring in January of 2017 traded at $1.74, call it $1.60 after expenses. Based on the $4,000 required to cash secure the option this premium could represent an immediate 4% starting yield.

Granted in the coming years you would need to again think about selling options to supplement your cash flow, as your starting yield would be "just" 3.5%. And naturally the same analysis as above applies.

A different consideration could look like this: buy shares today and then sell a covered call to reach your desired yield level. For instance, if you bought 100 shares at $4,400 you might expect to receive $140 in the coming year representing a 3.2% yield.

In order to generate that extra 0.8% you could look to something like the January 2017 call option with a $50 strike price. (Note that I have no affinity for this expiration date, a lot of investors prefer shorter time periods, but it gives you an idea of what's available on an annual basis.)

With this call option you could generate a premium of ~$0.35, bringing your total cash flow from owning shares of Coca-Cola up to 4% or so. Once again one of two things occurs in this scenario: either the option is exercised or it is not.

If the option is not exercised you collect your premium and continue holding as you normally would. When combined with dividends, your cash flow could be about 4%.

If the option were exercised, you would be forced to sell your shares at $50 each. This translates to a 14% to 17.5% return in less than a year, depending on whether or not you received dividend payments along the way. Here you want to be happy with either outcome. If you were not willing to sell at a 14% gain, then adding a bit of cash flow likely wouldn't be for you.

Of course you're not limited to just this $50 strike price example. Should you be willing to sell at $45 or $47 you could increase your immediate cash flow by 4% or 2.4%. In doing so you would simultaneously be "capping" your gain to 6% - 10% or 9% to 12% depending on whether or not you receive dividends.

In short, Coca-Cola has shown exceptional dividend consistency over the years. However, if you're waiting to own shares with a 4% dividend yield you could very well be waiting for a very long time. Of course there are a couple of ways to potentially reach this ambition: agreeing to buy at a much lower price or owning shares and agreeing to sell at a higher price. Both circumstances come with their own unique risks. In the end it's about figuring out your underlying goals and determining which option (if any) will work best towards that endeavor.

Disclosure: I am/we are long KO.

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.

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