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Thursday, April 1, 1999

An Investment Opinion
by Warren Gump

Nix the Dividend Yield

The sky is falling, the sky is falling! Sell, sell, sell. You might get that indication from people who are looking at the dividend yield of many stocks. Fast food giant McDonald's (NYSE: MCD) has a current dividend yield of about 0.4%, down from 1.0% at the beginning of the 1990s. And McDonald's isn't alone. Most other major companies have dividend yields that are well below those in recent memory. What's going on here? Are the low yields a reason to panic?

Before getting into the several factors impacting dividends, it's important to understand how the dividend yield is calculated. You take the dividends per share paid over the last twelve months and divide that by the current price of the stock. Looking at McDonald's, the company has paid out dividends of $0.184 per share over the past twelve months. Dividing that dividend by the current stock price of about $46 results in a dividend yield of 0.4%.

Hold on, my dear friend, that is the dividend that has been paid out over the past twelve months. What about the next year? As investors, we are always looking forward rather than backwards. Many companies, including McDonald's, raise their dividends each year. This past January, McDonald's raised its payout to 4.875 cents per share every quarter from 4.5 cents. Since this dividend is likely to continue over the next year, it is more appropriate to use the prospective dividend rather than the historical number. Multiplying the quarterly dividend by 4, we calculate the dividend over the next year to be $0.195. Using the current $46 price as the denominator of the calculation, we find the McDonald's prospective yield is 0.42%. Not a huge difference, but one I'm sure Mickey D's shareholders appreciate.

Why is that dividend so much lower than the 1% available at the end of 1990? The company must have run into a lot of trouble and cut the dividend somewhere in the past, right? Actually the answer is no. Since 1990, the dividend has actually increased almost 150% per share! At the beginning of 1990, McDonald's quarterly dividend was a tad under 2 cents per share, yet it is now almost 5 cents per share. That's compound annual growth of over 10% a year.

If the dividend has gone up and the dividend yield has gone done, only one culprit in the equation remains. The share price must have appreciated much more quickly than the dividend. This fact is undeniable -- the stock has risen from just under $9 to over $45, or compound annual growth of just under 20% per year. Does price appreciation greater than dividend appreciation indicate that a stock is overpriced? Not necessarily. The value of a company depends much more on its current and projected cash flows and earnings than on its dividend yield.

Despite not being a primary driver of valuation, a dividend does represent excess capital that is not needed by a company for other investments. The most important use of cash generated by a business is to ensure that a company is prepared to maintain and enhance its competitive position. This means investing in facilities and programs to ensure that a company is more efficient than its competitors. Cash is also needed by a company to address new growth areas. If the jingle of cash is left over on a balance sheet after these initiatives are covered, companies often return it to shareholders. Historically, cash earmarked for shareholders has been paid out in quarterly dividends.

Over the past several years, companies have significantly altered the method in which they return cash to shareholders. Instead of paying the money out in dividends, a taxable event for most individuals, the many companies have decided to return the funds to owners in the form of share repurchases, which are not subject to Uncle Sam's wide grasp. For investors with a long-term investment horizon, this switch is quite advantageous.

Let's assume that Cash Machine, Inc. generates $1 million in excess cash flow a year that it wants to return to shareholders. One option to distribute the cash would be to pay an annual dividend of $0.50 per share. Assuming a price of $10 per share and 2 million shares outstanding, this would represent a yield of 5%. For owners who reinvest their dividends into additional shares of company stock, the situation really stinks. A holder of 100 shares would receive a dividend of $50 that would then be used to buy an additional 5 shares. At year-end, however, good ol' Uncle Sam would open up his hands and request a deposit of $14. Thus, the owner would have 5 more shares, but would be out of pocket an additional $14.

An alternative for Cash Machine would be to repurchase its shares. If it used all its extra cash to repurchase shares and the stock stayed at $10 a stub, the company would buy back 100,000 shares with its $1 million cash horde. The question now becomes, which alternative is better for the shareholder?

Under the traditional dividend scenario, the shareholder bought 5 shares with her $50 dividend, but also paid $14 to Uncle Sam. At the end of the year, she holds 105 shares of a company with 2 million shares outstanding (0.00525% of the company). On the other hand, the shareholder whose company chose to repurchase stock holds 100 shares of a company with 1.9 million shares outstanding (0.00526%). I'll take the latter any day. You hold a higher percentage of the company and you get to defer gains to Uncle Sam until you decide to sell your investment, which will hopefully be years in the future.

As corporations have increasingly recognized the benefits of stock buybacks over dividends, they have slowed their dividend increases and increased the amount of stock repurchases. As a long-term investor, I'm fully supportive of this move. This change does, however, cause the dividend yield to become irrelevant. If companies substantially reduce their 'payouts via dividends, how can you know how much cash the company returned to shareholders? The solution is actually pretty simple. All you need to do is find out how much the company expended on stock repurchases over the past year (available on the cash flow statement) and add this to the dividends paid. I call this measure the modified dividend.

Modified Dividend Yield:

(Dividend per share + trailing 12 months repurchases per share) / stock price

Looking back at McDonald's, we already know that the company paid $0.184 per share in dividends. Taking a look at the company's recently filed 10-K, the company repurchased $1.1 billion worth of stock in 1998. With 1.4 billion average shares outstanding during the year, the repurchase equals about $0.766 per share. Plugging these figures into the formula, McDonald's modified dividend yield would be 2.07%:


That modified dividend yield is a better reflection of how much cash McDonald's is returning to shareholders than its traditional dividend yield. I would propose that you use such a measure to see what your companies are returning to you. Most people look at Intel (Nasdaq: INTC) and see a company paying a paltry dividend of 0.1%. I look at the company and its $6.8 billion in stock repurchases and see a modified dividend yield of 1.8%.

A yield calculation including stock repurchases will not hold as steady as the traditional dividend yield. Companies can easily alter the amount of repurchases on a yearly basis, whereas its considered a big taboo to reduce a dividend. (A reduced dividend payout usually only occurs when a company is in financial distress.) Although fluctuations in the numerator of the modified dividend yield will be more prevalent, I believe it is much more informative statistic than the dividend yield.

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