It came to light last year that Warren Buffett received a 50% annualized yield on his initial investment in Coca-Cola because of the company's dividend growth over Buffett's holding period. Some analysts call this 'forward yield' and actually, this is a great way of thinking about long-term investing. To explain how this works, I'm going to run through an example with my two favorite dividend stocks, Philip Morris International (PM -0.63%) and Altria Group (MO 0.92%).
Not so fast
However, before we go into forward yields, we need to take a look at these companies' current yields to establish whether they can sustain their current payouts. We also need to figure out whether these payouts have room to grow.
Actually, Philip Morris' management has been extremely prudent in ensuring the long-term sustainability of the company's dividend. In particular, after Philip Morris spun off from what is now Altria during 2008, in its first full year of independence the company generated free cash flow of $6.8 billion from which it paid out $5.1 billion in dividends to investors.
Now, Philip Morris could have paid out a lot more than this in theory, but the company's management remained cautious. Since then the company's payout has edged up, rising from an initial quarterly payout of $0.46 per share in 2008 to a quarterly payout of $0.94 per share as of the third quarter of this year.
However, while Philip Morris' payout has more than doubled it has only grown in-line with funds generated from operations. In particular, although Philip Morris' payout has risen more than 100% on a per-share basis during the past five years, the company's payout ratio has, for the most part, remained below 60% of free cash flow.
Unfortunately, Altria's dividend is under much more pressure than that of its larger, international peer.
Specifically, for the last five years, Altria has paid out a total of $16.7 billion in dividends. During the same period, the company has only generated a free cash flow of $17.7 billion, which gives a payout ratio of close to 94%.
Nevertheless, Altria has increased its payout 47 times during the last 44 years and the company aims to return 80% of diluted earnings per share to investors every year, which gives me confidence in the company's future payouts.
With that out of the way
So we know both Philip Morris and Altria can sustain their payouts, with room for growth, so what about forward yield?
Well, since Philip Morris came to market in 2008, its dividend payout has expanded 74%; that's over six years. If you bought Philip Morris shares on the first trading day of 2009, you would have paid $44.12 per share and you would have received an annualized dividend yield of 4.8%. However, today after five years of payout growth you would receive an annualized yield on your initial investment of 8.5%.
Additionally, we have already established that Philip Morris' dividend is safe and has room to grow. So, if we factor that in and say the payout grows by at least, say, 40% over the next six years, by 2020 Philip Morris' payout will be in the region of $5.20 per share. This is a near 12% annualized yield based on the 2009 purchase price and a 6.4% yield if you bought shares right now.
Not just tobacco
It's not just the tobacco companies that offer attractive forward yields of this nature. Kimberly Clark (KMB -1.27%) has been increasing its dividend payout in consecutive years for 41 years and the company looks like it's well placed to continue this trend.
For example, since the turn of the century (2000) the company's payout has risen from an annualized $1.08 per share to $3.24 per share as of 2013, that's a growth rate of around 9.6% per year. Further, Kimberly Clark's payout over the past five years has not exceeded 50% of free cash flow, so the company has plenty of room for further payout increases.
I should say here that Kimberly Clark produces a range of essential everyday products such as medical clothing, tissues, and feminine care products, all highly defensive markets. With this being the case, I'm confident in trying to calculate a forward yield figure for Kimberly Clark as the company's sales are unlikely to disappear overnight.
So, if we assume that the annualized 9.6% per year dividend growth rate will continue (there is no reason to suggest that it won't) we can calculate that Kimberly Clark's dividend payout will be in the region of $8.10 per share within 10 years. To put it another way, that is a 7.5% dividend yield on the current share price.
So, if you want to invest like Buffett and receive a 50% yield on your investment then you need to think about the future. Forward yield may not be what everyone considers when planning an investment but it is important in planning for the long-term.
Altria, Philip Morris, and Kimberly Clark are all great examples of companies that will keep those dividend payouts growing and over time investors will reap the benefits.