Dividend stocks give investors a cushion of cash flow when times get tough. Dividend Aristocrats,, the giants that have raised dividends for 25 years in a row, are among the most reliable dividend payers there are. McDonald's (NYSE:MCD) and Coca-Cola (NYSE:KO) are two such stalwarts. However, not all Dividend Aristocrats are created equal.
To decide which company is the better dividend payer, investors should analyze several factors: the company's dividend yield, its growth story, and the amount of earnings it pays out as dividends. Let's compare our Dividend Aristocrats on these measures to see which is the better investment today.
In baseball, the supreme measure used to compare hitters is batting average. For dividend stocks, it is dividend yield. Dividend yield measures the size of a company's annual dividend payout relative to its share price. It is calculated by dividing the annual dividend per share by the current share price. Think of yield as a quick way to figure out how much cash flow an investment will send your way each year through dividends. For example, a stock with a yield of 4% will slide over $4,000 annually (before taxes) on a $100,000 investment.
Coca-Cola has an advantage over McDonald's when it comes to dividend yield. Coke has a current yield of just over 3%, while McDonald's hovers around 2.25%. Looking back five years, McDonald's paid a yield closer to 3.5%, while Coke was still in the neighborhood of 3%. Why did the McDonald's yield drop while Coke's remained the same?
The answer can be found in the share price changes for each of these companies.
Coke's share price has risen by 26% over the last five years, whereas McDonald's shares have skyrocketed by 105%. Even if a company's dividend per share increases, the business's yield will decline if share prices increase faster than dividends increase -- the denominator of the yield calculation is increasing faster than the numerator. By digging a little deeper, we can uncover the stories behind these price fluctuations.
McDonald's sizzles, Coke sputters
Over time, every company will face its share of challenges. How management responds to these challenges will determine the fate of the business, and of shareholder returns.
Since 2015, McDonald's has been executing on a turnaround plan focused on slimming down its corporate management structure, serving up higher quality menu items, and delivering speedier customer service. These initiatives have shown up in stores in the form of Sirloin Third Pound burgers and sleek self-ordering kiosks that would not feel out of place on the bridge of the Starship Enterprise.
Even better, McDonald's plan has worked. Gross margins have increased by over one-thousand basis points and earnings have grown at a CAGR of 16.25%, since 2015. Think of those gross margins in terms of selling a hamburger -- gross margin is the sales dollars left over from selling the hamburger after you pay for the patty and the bun. For investors, McDonald's turnaround led to an outstanding run-up in its share price, which, in turn, knocked down its yield. This was great news for the guy holding shares back in 2015. For the investor seeking yield today, however, it could leave us hungry for more.
Turning to the world of Coke, the purveyor of pop has been slogging through a nightmare of consumers heading for the exits. Over the last 20 years, consumption of full-calorie soda has dropped by 25%, while bottled water sales have shot to the rafters. This exodus has fizzed up through Coke in the form of flat revenues and a tepid 1.88% earnings CAGR over the last 10 years. Management rallied in 2014 with a plan to bust the slump by using, among other tools, bottler refranchising and investments in healthier beverages such as organic, cold-pressed juices and plant-based protein drinks. However, unlike McDonald's blueprint, this line-up has produced limited results.
Over the last couple of years, revenues at Coke have dropped by double digits and over the last five years earnings growth has bounced from extreme lows of -81% to highs of 417%. Pings of salvation, however, have surfaced in the form of higher gross margins in recent years and comparable earnings growth of 9% in 2018. This last bit of news is refreshing for Coke shareholders, as it indicates the plan may be taking root. However, the previous onslaught led to stagnant share prices and left the yield hovering around 3%. For the investor holding shares in 2015, this turned out poorly, but for the investor looking for income today, this yield is more attractive than McDonald's.
When it comes to dividend yield, on first glance it appears that Coca-Cola is the Mickey Mantle of income investing while McDonald's is a minor league hitter. However, a closer look at the stories behind these yields reveals that McDonald's has been slugging away successfully while Coca-Cola has come up dry. A high yield alone does not prove that a company is a good investment.
Companies have a bevy of options for how to use their earnings. Management can use earnings to pay down debt, buy new brands, repurchase shares, or, in our case, pay out dividends. The amount of earnings paid out as dividends is called the payout ratio, which is calculated by simply dividing the company's per share dividend payments by its earnings per share. Think of the payout ratio as the amount of wiggle room a company has to continue paying out dividends. If the ratio is 100%, then the company has run out of room and is using all of its earnings to pay its dividends. Wise investors will check for a wide berth in the payout ratio.
For our Dividend Aristocrats, the expectations are that management will continue to raise dividends regardless of what earnings do. After-all, company leaders don't want to break investors' hearts by snapping a 25-year streak of dividend raises. These raises are not a problem for companies that are growing earnings. For those that have struggled, however, this is bad news.
McDonald's management has raised the quarterly dividend by a compounded rate of 7.4% over the last five years while earnings have grown at a CAGR of 6.32%. This has led to a payout ratio of around 60% which gives the company a healthy forty cents of wiggle room out of every dollar it earns to cover the dividend payment.
For Coke, though, things are becoming claustrophobic. Over the last five years, management has raised the quarterly dividend by a compounded rate of 5% while earnings have shrunk by a CAGR of nearly 5%. This disastrous pinch has led to a payout ratio of nearly 96%. This four cents of wiggle room should raise alarm bells for dividend investors, as unsustainable payouts lead to dividend cuts regardless of whether a company has a long history of dividend increases.
Dividend Aristocrats give investors a level of comfort that dividends will be paid and raised long into the future. However, a closer look at yields, growth stories, and payout ratios shows that not all Dividend Aristocrats are alike. In the face-off between McDonald's and Coke, we find that Coke's recent story is rife with slowing growth and a squeezed payout that threatens the cash flow to investors. McDonald's, on the other hand, has hit a solid line-drive with a turnaround plan that has grown earnings and created enough space to reliably cover continued dividend increases. Wise dividend investors hungry for yield will add McDonald's to their starting line-up.