Many investors treat dividends as an afterthought, as in, “Oh yeah, I also got $120 in dividend income last year.”
The fact is, over the long haul, dividends can be a critical element of the total return for many investors. That’s part of the thinking that went into the new Dividend Stars motif, which is comprised of larger capitalization stocks, with a track record of increasing dividend payments over the years, and which have had relatively conservative dividend-to-operating cash flow ratios.
To see how dividends can be important to long term returns, let’s look at its impact on just one stock, McDonalds (MCD).
Let’s say that in January, 10 years ago, you purchased $10,000 of MCD, which at the time was trading at about $14.50. Your $10,000 would have netted about 690 shares which, in 2003, was paying a dividend of $0.40 per share, or about $275 annually.
Fast forward to January, 2013. Now MCD sharesholders earn an annual dividend yield of $3.08. As a result, those 690 shares (assuming no reinvestment of dividends or sales of shares) now pay $1,980 (690 x $2.87 in the prior four quarters). The cash-on-cash return on the original $10,000 invested would be 19.8%, ($1,980 ÷ $10,000). And that’s just the return from the dividends. Over the same 10 year period, MCD shares have increased to $91.30 as of the close of trading on January 16, 2012. Those same 690 shares purchased in 2003, for $10,000 would now be worth $62,997.
There’s a school of value and income-oriented financial academics that believe investors should only buy dividend paying stocks. Proponents of this school feel that, income aside, companies forced to submit to the discipline of meeting shareholder expectations of regular cash dividend payments (and increasing these payments) are simply run with a more disciplined and investor-focused business model.
A portfolio of the 25 individual stocks that appear in the Dividend Stars motif had a composite return of 15.1% over the past 12 months, suggesting there may be some merit to this line of thinking.
Another consideration to determine if a dividend-paying stock may be right for you is finding companies that are generating enough revenue to grow the business, in addition to rewarding shareholders with a dividend payout. The dividend-to-operating cash flow ratio can help. In fact, the Dividend Stars motif excluded companies that have, “a dividend-to-operating cash flow ratio greater than 75%”. What does this mean precisely, and is it a good thing or a bad thing? It’s an advanced, and important concept, but also one that is easy to understand. First a quick definition of that technical term, operating cash flow.
Operating cash flow is generally considered to be revenues (once they have been converted into cash) less all the expenses (once they have been paid) and excludes things that aren’t really cash or operating expenses, such as depreciation on equipment, or loan payments.
Let’s use McDonald’s as an example again. McDonald’s full year 2011 data (2012’s information is not yet compiled) from a Standard & Poor’s January 2013 report shows about 1 billion shares outstanding. With the dividend that year at $2.53, MCD’s total dividend expense was $2.53 billion (1 billion shares x $2.53 in dividends per share). McDonald’s total operating cash flow was about $6.62 billion.
The ratio of the total dividend expense to the operating cash flow ($2.53 billion ÷ $6.62 billion) is 38%. What does this mean? The cash dividends MCD paid is 38% of the cash it generated. If the number were higher, say 80% or 90%, it could mean MCD was at risk to cut its dividend. Why? If revenues fell for whatever reason, it could turn out that 80% of the cash flow these revenues generated would not cover the $2.53 billion of anticipated dividend expense. Further, the need to meet the dividend payout inhibits company spend in other areas which can affect plans for growth.
The logic of the Dividend Stars motif to exclude companies with “a dividend to operating cash flow ratio greater than 75%” was intended to include the stocks of companies that are not likely candidates of a cash flow crunch that mathematically at least, could jeopardized their plans for dividend payouts to shareholders.
Another quick and dirty test to see what percentage of earnings are allocated to dividend payments is simply to take the annual dividend per share (DPS) and divide it by the annual earnings per share (EPS). Remember, earnings are not the same thing as cash flow, because of things like depreciation and interest on loans. Still, if the DPS/EPS is greater than 75%, and you are an income investor, you might want to take a close look to see if that stock meets your investing strategy.
Check out the Dividend Stars motif.
Past performance is no guarantee of future results. While certain companies may have consistently paid dividends in the past, there can be no assurance or guarantee that they will be able to continue paying dividends in the future.
Performance data was as of 01/17/2013. Performance data and returns are based on past performance and are not representative of results an investor could expect to achieve. The 1-month and 3-month return shows how a particular benchmark motif could have performed over a stated period of time. Returns of individual motifs do not take into consideration certain fees and/or commissions, corporate actions, or other activity that can affect the return an investor could expect to incur. The performance results attempt to follow a standardized and consistent methodology for performance reporting. While we believe the performance data is gathered from reliable sources, the information that generates performance results uses historical data that we believe to be accurate but has not been validated and may contain errors in pricing or other conditions. Reference to return of index does not imply its performance is comparable to a motif, but rather serves to provide a reference point. For detailed information on how we calculate returns, please visit www.motifinvesting.com.