7/29/2020
Using the dividend yield to screen stocks can be deceiving. It can lead to value traps and understates the benefits of rising dividends.
Not every company pays a dividend. Not everyone should. Dividends are a rarity for young companies who usually choose to reinvest profits in growth initiatives. Dividends are more common in mature companies, who are large enough to continue growing with their momentum and payout some of their profits in the form of dividends, like a big snowball.
The most common way dividends are judged is by their yield, more technically: their current yield. When you hear Apple pays a 0.89% dividend, that means its current yield is 0.89%; or a little less than 1% of its current stock price has been paid as a dividend to its shareholders over the last year. Unfortunately, current yield is a look in the review mirror and overly sensitive to the company’s stock price.
A better way to judge dividend payouts is how they grow over the years. Healthy, mature companies can increase their dividends by 5% to 15% a year. The dividend increases compound. A dividend paying stock averaging a 10% increase a year, over a 5-year holding period, will grow a $1 dividend to $1.61.
Returning to Apple’s dividend, you might not think that 0.89% is very sexy, especially when compared to Apple’s stock price appreciation. However, if you had bought shares in Apple five years ago at $123, and held it, your yield-on-cost would be 2.67%—that is the current dividend divided by the price you paid for the shares, $123 in the example of Apple. So, for holders of Apple stock over the last five years, their yield-on-cost is approximately 3-times what the current yield is for Apple, and much higher than the current 30-year U.S. Treasury bond at 1.22%. An investor’s yield-on-cost is not influenced by future stock prices, but by future dividend payouts because the cost, or the price paid, stays constant.
To further illustrate this, lets step outside of the stock market and think of a simplified real estate investment. Let’s say you bought a one-bedroom apartment five years ago for $100,000 and decided to rent it out for $500 a month, or $6,000 a year. Assume for this example that you had paid in full for the apartment and the tenet covers all costs beyond rent. Your yield-on-cost would be 6%, or $6,000 divided by $100,000. And being a very greedy landlord, you decide to raise the rent 10% a year, each year, for five years. The rent on the fifth year would be $9,663. The constant is the cost, still $100,000, and your yield-on-cost would rise to 9.663%—a 61% increase over the five years.
This example has a few take-aways. First, the power of compounding returns. In just a few years the rental income, and the yield-on-cost, is significantly higher. Second, in the real-world landlords cannot raise their rents by 10% a year, year after year, without suffering large vacancies. The average rent rises by 3-5% a year in normal times. Barring other factors, raising the rent by 10% a year is unsustainable. And third, it is a reminder that rental income is usually taxed as ordinary income—at your marginal tax bracket. Whereas qualified dividends in 2020 are tax-free for the bottom two marginal tax brackets; taxed at 15% for individuals who earn up to $434,500; and at 20% for those who earn more than $434,500.
But back in the stock market, Apple can grow their dividend payout by 10% a year, they averaged 10.7% growth over the past five years. And many other mature companies from all sectors of the economy can do the same.
Although, not all dividend paying companies are healthy cash cows that keep growing that yield-on-cost statistic. Some companies on the surface can have the appearance of being a dividend grower, but their capacity to keep that payout growing might be dubious. The measure of that capacity is the Payout Ratio, which is dividends divided by profits.
Apple’s payout ratio sits at about 24% of 2020 earnings. Meaning for every $1 Apple earns in profit, it pays 24 cents to investors in the form of dividends. That is a healthy level that Apple can payout and grow, even in profoundly harsh times, like say a pandemic. Compare that to Exxon Mobil, who has a long and distinguished record of raising their dividend, but now payout 139% of their earnings. That means, for every $1 Exxon earns, they pay $1.39 to shareholders in dividends. Much like trying to raise the rent year after year, Exxon’s capacity to raise their dividend is exceptionally low because they must raise debt, or sell assets, just to afford their current dividend.
Investors are often drawn to high current yielding companies by online market screening tools. After sorting by highest dividend yield (current yield), there are hundreds of companies to choose from with dividends in excess of 15%. Most who invest in these companies only find out later, after the company has lowered or canceled its dividend, that they have been caught in a value trap.
A value trap is any investment that, on the surface, appears to be cheaply priced relative to a valuation metric, like earnings, revenue, book value, or dividend yield. The trap comes when the investor realizes the investment was cheaply priced because those valuation metrics do not reflect what that company is capable of in the future.Value traps are one of the greatest all-time killers of capital. They successfully kill investment dollars because they appear so attractive. What looks better on the surface, a current yield of 8.1% (Exxon) or 0.89% (Apple)? But, just below the surface, the quality and sustainability change the investment calculus. This is not to say all high yields are bad, rather all dividend yields must be compared with their payout ratios. Further, this is not a recommendation to buy Apple, or to sell Exxon Mobil, only to judge any dividend payouts with deeper scrutiny.
To avoid value traps and find rising dividends, use the payout ratio as a guide to judge the quality and sustainability of the current yield. But over the course of an investment, use yield-on-cost to gauge what you receive in dividends. What you will find is rising dividends are an overlooked gem.
By Justin Hudock
Starboard Wealth Management
Marstons Mills, Massachusetts