There are many different things to consider before buying an ownership interest in a publicly traded company. These include the business model, valuation, and historical earnings growth. Another important consideration is the dividend. It's important to remember that from 1930 to 2012, dividends accounted for about 42% of the gains in the S&P 500.
Many investors pursue dividend-paying stocks to augment their returns with a nice income stream.
Tobacco companies are some of the biggest dividend-paying companies around, and income investors often flock to them for the unique combination of a high yield and strong dividend growth. Let's take a look at the dividends of Altria, Reynolds American, and Lorillard to see who has the strongest dividend of the three in terms of investor return, sustainability, and future growth.
The most obvious consideration when comparing dividends from different companies is the dividend yield, which represents the percentage of your investment that you receive back over the next 12 months, provided that the dividend doesn't change over that time.
Table 1: Dividend Yields of Altria, Reynolds American and Lorillard
Note that these dividend yields are forward yields that include the most recent announced dividend increases from Reynolds American and Lorillard this past month. When it comes to the strongest dividend yield, it is a tie between Altria and Reynolds American.
When analyzing a dividend, it's not all about the yield. As an income investor, you want that dividend to grow over time in order to protect your income stream from the erosive effects of inflation, as well as to show confidence from management in the company's outlook. Table 2 shows the average dividend growth rate from our three companies over the last five years.
Table 2: Five-Year Dividend Growth Rates From Altria, Reynolds American, and Lorillard
Table 2 shows impressive dividend growth rates for all three companies that easily outpace inflation. While Altria and Reynolds American look very strong in this category, Lorillard has by far the strongest five-year dividend growth rate, north of 14%.
Altria has increased its dividends 47 times in the last 44 years. Of course, during a lot of that time, Altria still owned Philip Morris International and Kraft Foods. Reynolds American has increased its dividend 7 times since 2009. Lorillard has increased its dividend every year since being spun off from Loews Corp. in 2008.
In terms of the five-year dividend growth rate, Lorillard wins out here.
Free cash flow payout ratio
While high dividend yields and strong dividend growth are nice, we need to make sure that the company in question can generate enough cash flow to cover its dividend payment. The free cash flow payout ratio tells us what percentage of the company's free cash flow is eaten up by dividend payments. Lower free cash flow payout ratios are better, as they leave more room available for future dividend increases or other uses of the capital.
Free cash flow is the cash flow a company generates in its operations minus capital expenditures.
Table 3: Free Cash Flow Payout Ratios Of Altria, Reynolds American, and Lorillard
Table 3 shows that both Altria and Reynolds American are paying out extremely high percentages of their free cash flows in dividends. This means that in order for these two companies to continue increasing their dividends every year, they need to increase their free cash flows too.
Lorillard has the lowest free cash flow payout ratio of the three. With their most recent dividend increase of 12%, it will be interesting to see if this ratio rises to be more inline with those of the other two companies over the coming year.
Earnings per share growth forecasts
While it's good to look at what past dividend payouts have been and how they relate to past earnings, we need to get an idea as to what future dividend payouts are going to look like. One of the ways in which we do this is by looking at analyst forecasts for earnings-per-share growth.
Table 4: Earnings Per Share Growth Forecasts For Altria, Reynolds American, and Lorillard
Table 4 shows that while both Altria and Reynolds American are expected to grow earnings per share in the upper single-digit range over the next couple of years, Lorillard is expected to grow at a double-digit rate over the same time period. This bodes very well for future dividend growth, as dividends come from free cash flow, which comes from earnings.
While all three companies have strong dividend yields and track records for dividend growth, Altria concerns me a bit, with dividend payouts eating up nearly all of its free cash flow. In the case of Reynolds American, dividends are currently eating up all of its free cash flow. This means that in order to continue increasing their dividends, these two companies will need to continue increasing their free cash flows. Based on this, along with earnings per share forecasts, we can expect to see continued dividend increases in the mid to upper single-digit range for both Altria and Reynolds American.
Lorillard, on the other hand, has the highest dividend growth rate, the lowest free cash flow payout ratio, and the strongest earnings-per-share growth forecast. While 12% dividend increases usually don't go on forever, based on the figures outlined above, Lorillard's dividend looks very sustainable and primed for more growth than those from Altria and Reynolds American, as long as the FDA doesn't ban menthol cigarettes.
I am long MO.