Can You Win With Dividends Alone?

I'm a McDonald's (NYSE: MCD  ) shareholder and a big fan of the company. Historically, you have a solid business that has found a receptive market for its quick-serve grub around the world.

More recently, the company has been reinvigorating the company's image with new initiatives like offering premium coffee drinks, remodeling stores, and focusing on the quality of its ingredients. And from a financial perspective, competitors like Wendy's/Arby's Group (NYSE: WEN  ) and Jack in the Box (Nasdaq: JACK  ) can't hold a candle to what McDonald's delivers for its investors.

And, of course, McDonald's treats its investors to one of my very favorite things in the whole world: a dividend. And not only is it a dividend, it's quite a nice dividend -- currently the yield on McDonald's stock is 3%, which is above what you can get from a 10-year Treasury note. Need more? The company's payout has grown 31% per year over the past five years.

But...
What was tempting to me was the idea that McDonald's could be a value based simply on its dividends. So I took a shot running a valuation on McDonald's using a dividend discount model.

Unfortunately, the results aren't terribly inspiring. While McDonald's dividend has grown by leaps and bounds in recent years, it'd be folly to predict that growth will continue at that rate because continued dividend growth well above the rate of earnings growth would bring the company's payout ratio to an unhealthy level.

Considering this, I assumed that payout growth would be 14% over the next decade. That's still pretty fast, but if the company is able to maintain 10% earnings growth, then the payout ratio shouldn't go beyond 75%. I further assumed that the perpetuity growth rate of the dividend is 4%.

Using a 12% discount rate, that brings McDonald's per-share value to roughly $56 -- not exactly what you want to see when the stock is trading at $74.

To be fair, I think you'd be hard pressed to find a reasonable valuation model that would show McDonald's to be vastly undervalued, but when I look at the shares with a cash flow- or earnings-based model, the result makes today's price look much more reasonable.

Dividend-only rock stars
Don't worry, there's nothing wrong with McDonald's or its dividends. Like many other strong, growing companies out there, McDonald's dividends will contribute to overall returns in the years to come and will likely help make the stock a good portfolio addition. But investors will have to look outside of dividends for part of their returns as well.

But are there companies out there that can stand on dividends alone? They're definitely tougher to come by, but they're out there. Here are a few that I was able to track down.

Company

Dividend Yield

Average Annual Five-Year Dividend Growth

Payout Ratio

Reynolds American (NYSE: RAI  )

6.4%

13.3%

102%

Annaly Capital Management (NYSE: NLY  )

15.9%

8.9%

140%

Energy Transfer Partners (NYSE: ETP  )

7.7%

7.2%

135%

Maxim Integrated Products (Nasdaq: MXIM  )

5.1%

16.3%

195%

Senior Housing Properties Trust

6.2%

2.4%

177%

Source: Capital IQ, a division of Standard & Poor's.

Using a simple dividend discount model and trusting analysts' growth estimates (yes, I know that can be a dicey move), all of the stocks above could be considered good buys based on their dividend returns alone.

There are a few things we can highlight about these companies. Probably most obvious are the dividend yields. Annaly may be far and away the highest at 15%-plus, but 5% and 6% yields are nothing to sneeze at when investors have bid down 10-year Treasury yields to nearly half that.

For the most part, these are also all pretty stable, boring companies. Reynolds American is behind a slew of tobacco products including Camel and Pall Mall cigarettes, Energy Transfer Partners owns natural gas transportation and storage assets, and, as the name suggests, Senior Housing Properties owns properties like nursing homes and senior apartments.

And wary investors will also notice that the payout ratios are particularly high here. But it's this last point that makes these companies compelling based on their dividends alone -- these companies produce cash flow well above their accounting profits and focus on delivering most of that cash flow to investors. Maxim, for instance, paid dividends that were almost double its accounting profits over the past 12 months, but the company's free cash flow -- that is, cash from operations less capital expenditures -- of $367 million was more than enough to cover its $244 million in dividend payments.

Should you bite?
Annaly Capital has been quite the popular dividend stock lately, and I can see how a case could be made for it. But frankly, I'm not much of a fan of Annaly's business model and am lukewarm at best on the future stability of its dividend. That said, I think the rest of the group contains some pretty compelling plays for payout-hungry investors.

But it's also important to recognize what you're giving up as an investor with companies like this. Because most of the cash is being pumped out of the company, growth will likely be slower. For the same reason, the company may need to tap debt and equity markets more often when it does need capital. And the uncertainties over dividend taxation are even more worrisome when you're expecting most of your returns through dividends.

Investors focused primarily on current income will likely revel in these kinds of dividend-heavy plays. If you ask me though, I think these are best used as part of a diversified strategy, with more focus being put on companies that strike a balance between paying dividends and using cash to drive returns in other ways.

How do you protect your wealth from another recession? Would it surprise you if I said dividends?

Motley Fool Options has recommended writing puts on Jack in the Box. The Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Matt Koppenheffer owns shares of McDonald's but does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookies were harmed in the making of this article.


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  • Report this Comment On August 31, 2010, at 4:50 PM, rd80 wrote:

    "Using a 12% discount rate, that brings McDonald's per-share value to roughly $56 -- not exactly what you want to see when the stock is trading at $74."

    Matt,

    Interesting article.

    For full valuation, you should consider the capital value of the stock at the end of the DCF period along with the value of the dividend stream. To add more color, if MCD stock price appreciates to maintain the same 3% yield it has today, pps in 30-years would be nearly $600. Discounting that back to present value at 12% comes to a bit over $22.

    $56 for the dividend plus $22 for the equity puts a fair value for the stock today at $78 using the 12% discount rate, your dividend growth assumptions and my assumption that the stock price will keep the yield at about 3%.

    A more interesting valuation is the stock and dividend stream 10 years out using the same assumptions. The dcf of the dividend stream is only $27, but the discounted present value of the stock would be $98, $270 in then-year dollars. Basically, you wouldn't want to continue holding the stock once the dividend growth rate falls off below your discount rate.

    Disclosure: Long MCD

  • Report this Comment On August 31, 2010, at 6:08 PM, TMFKopp wrote:

    @Todd

    Hey, thanks for the comment!

    Yeah, I get aggressive on my COE and it's basically because I use it as a return hurdle rather than the full-on calculation (I talk a bit about it here -- http://www.fool.com/investing/dividends-income/2010/08/24/ho....

    An 8-9% COE might be more realistic, and that certainly brings the valuation into a much more interesting range. However, I think investors sometimes overlook what it means when they knock down the COE. Sure, at 8% MCD might look undervalued, but it's undervalued assuming you're cool accepting 8% returns.

    Of course in the end when it comes to tossing in COE's you're really ending up with semantics to some extent -- somewhat overvalued at 12% or somewhat undervalued at 8%, basically the same thing just different expectations.

    Matt

  • Report this Comment On August 31, 2010, at 6:23 PM, TMFKopp wrote:

    @rd80

    "$56 for the dividend plus $22 for the equity puts a fair value for the stock today at $78 using the 12% discount rate, your dividend growth assumptions and my assumption that the stock price will keep the yield at about 3%."

    Sort of. Except that you wouldn't get the full $56. That assumes you collect dividends into perpetuity, but if you are considering the value of the stock then you have to assume you've sold it and are no longer collecting the dividends into infinity and beyond.

    Sort of like getting the goose's golden eggs forever versus collecting the eggs for a while and then having a goose sandwich down the road (ok, ok, selling the goose to a willing investor, but the first version is tastier).

    "A more interesting valuation is the stock and dividend stream 10 years out using the same assumptions."

    I see what you're getting at here, and as I noted in the article, I think there are valuation methods (like this) that make MCD's price today look a lot more attractive. But part of the beauty of the DDM for me is that you don't have to rely on the vagaries of the market for returns, just the company's ability to pay out that growing stream of dividends. Backing into a stock price based on a dividend yield has implications for market valuation of the shares.

    In this case, I've set MCD's dividend growth above the growth rate of its EPS, so you end up with a progressively higher payout ratio through year 10. Based on a ~75% payout ratio in year 10, we can back into the earnings, and comparing that to prospective PPS (using 3% dividend yield, I came up with a slightly lower PPS than you), the P/E at year 10 is somewhere in the 25 ballpark.

    Matt

  • Report this Comment On September 01, 2010, at 7:08 AM, thomfahr wrote:

    Basically, invest in companies that produce food, provide energy and helps you with your addictions ;)

    If you manage to survive al the fat foods and tobacco addictions and end up in a nursing home, that's also good!

    Happy investing!

    Thom

    Dividend Aristocrats - http://www.dividend.co.nr

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