Crazy But True: Why Visa Shareholders Don't Really Want a 2.6% Dividend Yield

All 30 Dow Jones (DJINDICES: ^DJI  ) components pay a dividend these days. The average Dow dividend offers a 2.6% yield. The single weakest yield, just 0.8%, comes from credit card processor and blue-chip index newcomer Visa (NYSE: V  ) .

But Visa shareholders should not really want their dividend yield to match up with the Dow's average level. Here's why, in two parts:

Visa shares are crushing the Dow, thank you very much
Since Visa started floating shares on the open market in 2008, the stock has absolutely demolished the Dow's returns:

V Chart

V data by YCharts.

Meanwhile, Visa's board of directors has done its best to provide strong payouts. Dividend checks are growing even faster than the share price. What more can an income investor ask for?

V Chart

V data by YCharts.

Unfortunately, the rising dividend payouts still haven't lifted the yield out of the Dow's deepest basement. The current 0.8% yield is one of the richest levels Visa has ever reached. Meanwhile, other stocks hovering near the bottom of the Dow's dividend yield ranks rarely dip below 1%, and never come close to Visa's ultralow effective yields.

Nota bene: Please ignore the temporary downward spike in Walt Disney's (NYSE: DIS  ) yields here. That's a charting artifact that comes from Disney sending out dividend checks once a year rather than once a quarter. This practice occasionally leaves a short gap for charting purposes, but never affects real-world dividend returns or yields.

That being said, here's how the four lowest-dividend yields on the Dow today have played out over the last four years. Nike (NYSE: NKE  ) , American Express (NYSE: AXP  ) , Disney, and Visa all have beaten the Dow soundly. They share the same nice-problem-to-have, namely rapidly rising share prices. It's just that Visa has outgained them all:

V Dividend Yield (TTM) Chart

V Dividend Yield (TTM) data by YCharts.

There's a limit to how much cash Visa can share with investors
So Visa is suffering from fantastic share price returns. Cry me a river, right? But that's not all.

Let's say that Visa's shares had followed the Dow's returns since that 2008 IPO. At 42% above the first day's closing prices, Visa shares would be trading at $91.30 today. The current dividend policy would then amount to just 1.7%. That's still far below the average Dow yield.

After five years of rapid dividend boosts, Visa currently pays out $934 million a year in the form of dividend checks. That's 13% of its free cash flow.

Meanwhile, Visa buys back shares on the open market by the truckload. Over the last 12 months, the company collected $7.2 billion in free cash flow and spent $4.5 billion on buybacks. At times, Visa goes beyond cash flow and dips into its cash reserve to finance its share repurchases.

V Total Dividends Paid (TTM) Chart

V Total Dividends Paid (TTM) data by YCharts.

I think it's fair to say that Visa is returning as much cash to shareholders as its leadership is comfortable with. Most of it just happens to be in the form of share buybacks. Drastic dividend increases above the established pace of payout growth, then, don't seem terribly likely.

To reach that magic 2.6% Dow average yield at current prices, Visa would have to boost its annual payout spending to $3.4 billion. (Such a move would also play havoc with share prices, likely raising the dividend spending bar even further as investors flock to the fortified payout. But this a thought experiment, so friction is always zero and every cow is perfectly spherical. And in that world, Visa's share price would not be moved by a sudden dividend explosion.)

So $3.4 billion would amount to 47% of Visa's trailing free cash flow.

Keep in mind that Visa's cash flow has not exactly been a model of stability in recent years. The company would be wise to keep a decent margin of safety between dividend expenses and expected cash inflows. Investors don't take kindly to sudden dividend cuts, if the new payout levels should ever prove too generous.

Buyback programs don't get anything near the same level of investor scrutiny, so Visa can rebalance its buybacks without worrying about investor backlash.

All things considered, Visa might be able to double its yield in exchange for lower buyback budgets, then still have enough wiggle room to adjust to future changes in the consumer debt market and the global economy at large. That yield would still stop at just 1.6%, though -- far below the Dow's 2.6% average.

So Visa's dividend yield is low for good reason. The company is boosting its payouts near the limits of what's reasonable, and yields are staying low because the darn share price keeps growing even faster.

The only way to lift Visa's yield above 2.6% and keep a straight face would be to give the company's cash flow a downright radical boost. However, that might not be in the cards as Visa stares down a dramatic change in the payment processing market.

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