Consider a Stock's Current Dividend and the Company's Core Growth Potential

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Consider a Stock's Current Dividend and the Company's Core Growth Potential

If we can establish that a stock’s current dividend is sustainable long term, we can take the stock’s current yield and, voila, one chunk of our total return is accounted for. Taking a dividend for granted means establishing long-term sustainability. Nothing lasts forever, although a few stocks, such as General Electric (GE), have dividend records that come awfully close to immortality.

What to look for

What establishes a secure dividend? Look for manageable debt levels. Remember, bondholders and banks are ahead of stockholders in the pay line. Next look for a reasonable payout ratio, or dividends as a percentage of profits. A payout ratio less than 80% is a good rule of thumb. Finally, look for steady cash flows. Also demand an economic moat: No-moat companies tend to be cyclical (think autos and chemicals) and lack the pricing power to maintain earnings during the inevitable industry downturns.

What it can look like

We can illustrate this with an example. Recently, the shares of Modern Widgets, Inc. (which is based on a real company) were changing hands at about $45 while paying a $1.10 annual dividend. At that time, the payout ratio was reasonable (52% over the previous 12 months), cash actually exceeded debt (no debt worries), and operating cash flows were consistent. Best of all, the firm’s moat is very wide. Its yield at that point was 2.4% ($1.10 / $45), giving us the first building block of prospective total return. And based on current earnings power of roughly $2.00 per share, we’ll have $0.90 in retained earnings to fund dividend growth.

Analyzing dividends: assess the company’s core growth potential

One key to the analysis of dividends is understanding how much investment is required to fund their growth. Few areas of the market are bursting at the seams, but most companies and industries have at least some growth potential over time as the U.S. economy expands (figure 3–4% per year plus inflation) and emerging markets open up. Inflation can be a tailwind, too—though taking price increases for granted with manufacturing-oriented firms is not necessarily a good idea. Fortunately for most mature businesses, supporting this baseline level of growth is relatively inexpensive, and therefore high-return.

Another and often simpler way to think about the cost of growth is to look at the company’s free cash flow as a percent of net income. Since free cash flow includes the cost of capital investments that support growth initiatives, the difference between earnings and free cash gives us a sense of the cost of growth.

To illustrate

For example, let’s say free cash flow consistently totals about 60% of net income, while sales and profit growth run about 6%. This suggests that only 40% of earnings will support this growth, leaving the other 60% of net income available for dividends, debt reduction, share buybacks, and other noncore investments.

This core growth gives us the second chunk of our total return equation. For hypothetical Modern Widgets, Inc. (based on a real company), let’s assume 5.2% growth in operating income over the next five years, and that Modern Widgets’s growth will fall significantly below that figure thereafter. Assuming that management maintains the current payout ratio, the firm’s total dividend payout should rise at a similar clip. So we bolt on this 5.2% growth to our prospective total return, bringing our expectations (including a 2.4% yield) to 7.6%.

But we’ve got one more task before moving on to the third and final step—how much will achieving this 5.2% growth cost? One of the simplest angles is to take the growth we expect (5.2%) and divide that by a representative return on equity (a nifty 30.8% for Modern Widgets, Inc. in the past five years). The resulting ratio—call it "R-cubed" for "required retention ratio"—is the proportion of earnings used to fund core growth. For Modern Widgets, the R3 is 17% of income, or $0.34 per share.

After-tax return on invested capital (ROIC) is also worth a look. ROIC is actually the purest way of analyzing the incremental cost of growth; in our formula ROIC replaces return on equity in the calculation of R3. However, ROIC is more complex to use, and it leaves out the company’s capital structure (mix of additional borrowings and retained earnings) that is reflected in ROE. If the capital structure is stable and returns on equity are consistent—Modern Widgets, Inc. checks out here on both counts—ROE is a good metric to use.

We’ll stick with ROE R3, and estimate 5.2% annual growth will cost Modern Widgets, Inc. $0.34 per share. Over time the absolute number will grow, but the proportion (17%) will remain the same as long as its two factors—growth and return on equity—stay the same.

We’re up to a 7.6% return, and we still have $0.56 per share to spare ($2.00 in earnings less $1.10 for the dividend and $0.34 to fund core growth). So what’s the final $0.56 per share worth?