In recent weeks I've been discussing how to estimate expected stock returns. So far I've looked at pinning down growth and dealing with valuation multiples. Today, we'll put the cherry on top by looking at dividends and share count.
There's nothing wrong with strong earnings growth and the potential of selling your shares at a higher price in the future. However, particularly after the experience of the past decade, many investors are realizing that a company that actually pays them regularly is a company worth hanging onto. Not to mention the fact that historical experience has shown dividend payers to be very kind to a portfolio.
But first...
Before we get to dividends, though, let's take a moment to talk about a company's share count. As I discussed in the first installment of this "Back to the Basics" series, a stock represents partial ownership in a company. However, that ownership stake isn't fixed, and a company can issue new shares (or buy back current shares), thereby reducing (or increasing) the ownership stake for each share.
Investors who focus on a company's per-share earnings growth when estimating growth may not have to address share count separately since earnings-per-share growth should take changes in share count into account. However, some extra attention here can't hurt because big changes in share count can drastically impact your investment.
The five years ending in 2010 may have been a bit unusual because of the financial crisis, but huge losses at major financial firms led them to sell gobs of new shares to shore up capital levels. Citigroup's (NYSE: C) share count increased 475% over that time, while E*TRADE's (Nasdaq: ETFC) shot up 449%, and Bank of America's (NYSE: BAC) expanded by 141%. The massive dilution at these companies clobbered their shareholders, and investors would be well advised to take this dilution risk into account when considering an investment.
But gauging share count changes isn't just about gauging downside risk. Companies like AutoZone that buy back shares and reduce share count can provide a serious tailwind for the stock. That said, not all buybacks are made equal, and it's important to make sure that a company is using its money wisely.
The other use of cash
As noted above, dividends are a prime contributor to stock returns and -- particularly if you reinvest those dividends -- one that tends to amplify over time.
So what do we need to know about dividends? The best starting point is the stock's current payout. With most companies -- particularly U.S. companies -- this is a pretty simple matter. Current dividend yield can be found on a stock's CAPS page, Yahoo! Finance, or any of a number of other online stock sites. Sometimes these sites get it wrong, but most of the time the data is good.
The alternative is to go to the company's investor relations page and get the information directly from the source. I would recommend the latter for most foreign-company dividends since I've found that stock websites have a tendency to get those payouts wrong more often than not.
Once we've got the current payout, we'll want to figure out how fast we can expect that dividend to grow in the future. As I suggested in my overview of estimating earnings growth and valuation multiples, your best bet is to create a range of possible scenarios rather than try to guess at a single value.
In creating your dividend growth range, I suggest starting with these four sources:
- Management guidance -- Sometimes management will set a clear goal for dividend growth. That doesn't mean that they'll live up to that goal, but it's a great place to start. Unfortunately, this isn't all that common.
- Historical dividend growth -- As we know, past performance is no guarantee of future results, but it can be a guide. Look at how fast the company grew its dividends over the past three, five, and 10 years. Look for trends like accelerating or decelerating growth, and check to see if the company is consistent with its dividend or has cut it in the past.
- Earnings growth -- Look back at the earnings growth estimates you've made (you have done that, right?). While it's possible for a company to grow its dividend faster than earnings for a time -- or decide not to increase it as fast -- projected earnings growth can be a helpful guide.
- Payout ratio -- This refers to the percentage of net income that a company pays out as a dividend. So if a company earns $1 per share and pays a dividend of $0.50, then its payout ratio is 50%. A lower payout ratio not only cushions a company's dividend through tough times, but it also could allow management to grow the dividend faster than earnings.
Work it out
Let's look at a couple of quick examples to see how this might work.
| Coca-Cola (NYSE: KO) | |
|---|---|
|
Share count |
We have nothing to worry about here. Over the past decade, Coke's share count has declined by 6%, and it's fallen by almost 3% over the past five years. |
|
Current dividend / yield |
$1.88 / 2.9% |
|
Dividend growth |
Coke has been a very reliable dividend payer and grower. The 10% growth rate of the past decade has decelerated to 9% over the past three years, but the company has healthy earnings growth and a low current payout ratio. |
|
Dividend growth range |
Due to the factors above, I would set a pretty tight range for Coke -- 10% at the high end, 8% at the low end, and a continuation of the recent 9% rate as the "base case." |
Sources: Capital IQ, a Standard & Poor's company; Motley Fool CAPS; and author's calculations.
| United Parcel Service (NYSE: UPS) | |
|---|---|
|
Share count |
Similar to Coke, we don't have much to worry about here. There's only been one year in the past decade where UPS didn't decrease its share count. Overall, the company has reduced its shares by 15% over that period. |
|
Current dividend / yield |
$2.08 / 2.9% |
|
Dividend growth |
There have been a couple of years over the past decade that UPS hasn't grown its dividend, but overall it's a reliable payer and its total payout has increased 176%. However, UPS' dividends' growth rate has slowed markedly. Over the past 10 years, it was 10.7%, but it's been just 7.3% and 3.8%, respectively, over the past three and five years. |
|
Dividend growth range |
A moderate payout ratio and healthy expected earnings growth should definitely support further dividend growth, though it may be slower than the past decade's rate. I'd set my range between 3% and 9% with a midpoint of 6%. |
Sources: Capital IQ, a Standard & Poor's company; Motley Fool CAPS; and author's calculations.
Put it to work
At this point, you now have the tools necessary to estimate a stock's returns based on four factors: earnings growth, valuation multiple, dividend growth, and share count. What's next? Getting down and dirty with some stocks!
To see what that looks like, you can take a peek at my analysis of Suburban Propane Partners (NYSE: SPH) and Sysco (NYSE: SYY).
You can also catch up on the rest of the "Back to the Basics" series if you've missed any of it:
