As I've written about, most recently in Tending the Dividend Garden - March Update, I like to group my stocks into several categories that I relate to crops from my garden. I believe this is an apt analogy because investing and gardening both require similar traits like planning and patience. My groups are defined solely by a stock's dividend yield and dividend growth rate (DGR). The examples of my crop categories are Microsoft (NASDAQ:MSFT) for apple tree, Target (NYSE:TGT) for strawberry, Johnson & Johnson (NYSE:JNJ) for green bean, AT&T (NYSE:T) for watermelon, and Realty Income (NYSE:O) for spinach. These two metrics are by no means the only criteria I measure a stock by when performing my due diligence, but organizing my stocks based on their dividends helps to keep me balanced between the high-yielding, low DGR stocks and the low-yielding, high DGR stocks. In this article, I will explore the dividend of International Business Machines (NYSE:IBM) a bit deeper and evaluate valuation in terms of the dividend. I'll also analyze future prospects and explain why while IBM looks fairly good on the surface, the DGR is likely to drop in the near future.
I consider IBM a strawberry stock within my Garden Portfolio. Much like strawberries, the yield begins modestly, between 2.5% and 4%, but experiences modest growth each subsequent season due to DGRs at 7-15%. IBM is near the top of the category in terms of yield, currently sitting at 3.86%. IBM is also a Dividend Contender with its streak of paying increasing dividends that was extended to 22 years earlier this month.
IBM has DGRs of 10.0% 1 year, 14.1% 3 year, 13.7% 5 year, and 17.5% 10 year. The 10-year DGR is quite impressive, but in order to ascertain how much the growth rate has slowed, I'll look at the 5/10 year DGR ratio. In this case, it's 0.78, meaning the 5-year DGR is 78% of the 10-year dividend growth average. That is a modest slowdown, but not all that alarming given the 3-year DGR shows a bit of acceleration with a 3/5 year DGR ratio of 1.03. The DGR was destined to drop off a bit at some point, but even the 1-year DGR of 10% looks great to me.
One metric I use to shed some light on a stock's valuation is how the current yield compares with the 5-year average yield. As written above, the current yield is 3.86%, while the average historic yield is 2.60%. In order for the yield to fall to this level, the share price would have to jump to over $230 for a rise of 48.5%. This would imply IBM is largely undervalued at this level, but I suspect this discrepancy may be more related to high DGRs and a stagnant stock price. Another metric I'll view next to its historic average is the payout ratio. IBM currently has an EPS payout ratio of 49.3% and its 10-year average payout ratio is 26.2%. This is further evidence that IBM may not have the bright future that some metrics indicate it might. The DGRs look to be funded mainly by this increased payout ratio which is not sustainable.
The growth of a company is generally the driving force behind an increasing dividend. However, over the past 5 years, IBM has experienced earnings contraction of 1%. When that is combined with the fact that the DGR over those 5 years was 13.7%, I'm more confident that the DGR was funded by an increased payout ratio, increased debt, or both. Turning to the future, the estimated growth for the next 5 years is 2.6%. While certainly better than negative growth, it would indicate to me that the coming DGRs will suffer, especially with how high they are currently.
The last piece of datum that I'll use to estimate the future dividend payments is the debt to equity ratio. IBM has a D/E of 2.33. While not the most troubling I've seen, it is higher than I would prefer. I think it gives credence to my theory of using debt to fund the increasing dividend payments of the last 5 years. I may be calling the drop off too soon, but I anticipate a DGR slowdown has to occur in the next couple years. For my purposes, I'm going to estimate raises dropping around 1% from the most recent raise of 10% each year for the next 5 years to bring the DGRs closer to earnings. I project the total dividend payment per share to be $35.63 for a payback of 22.9% over the next 5 years. This equates to a "bonus" share of IBM through reinvested dividends by June of 2022 for every 5 shares held today.
IBM is what I call a strawberry stock with its moderate yield and double-digit DGRs. At least as of this writing it is, because I can't imagine DGRs topping 7% for much longer. I came to a similar conclusion regarding where IBM is headed in a my previous article, IBM Takes Down Microsoft and Apple?. At first glance, IBM looks pretty good, but with the high D/E and low earnings projections, I'm not interested in adding any shares to my portfolio. Thanks for reading.
Disclosure: I am/we are long JNJ, MSFT, TGT, T, O.
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.