Dividends Can Pay You Back
Dividend yields have trended generally lower over the last 20 years, and the income return on large-company stocks topped 3% only once since 1992.
From 1980 through 2009, according to Morningstar, a $1,000 investment in large-company stocks produced an income return of about $2,427, a small fraction of the total return of $24,375. Nevertheless, dividends and yields are hugely important to individual investors. Dividends provide an income stream that can make investors feel more secure, as well as smooth the volatility of portfolio returns. And, in some cases, dividends can pay back a shareholder’s original investment within 10 to 15 years.
While the time required for dividends to pay back an investment is not the optimal way to model expected return, it is not the worst. Also, the knowledge that a stock’s dividend stream is steadily recouping the cost of its purchase might make some investors more willing to buy and hold quality stocks.
Here’s how payback works: Suppose you buy one share of Abbott Laboratories ($50; ABT). If the stock price stagnates and the company never increases its annual dividend of $1.76 per share (equating to a 3.5% yield), you will recover your investment in nearly 29 years. But Abbott has boosted its dividend at an annualized rate of 9% over the last 10 years, and companies that have consistently raised their dividends tend to continue doing so. If the dividend keeps growing at a 9% clip, you will recoup your investment through dividend payments in 14 years.
The key to a quick payback is dividend growth, and the key to dividend growth is rising earnings. The S&P 500 Index’s dividend payments have declined on a year-over-year basis in each of the last six quarters. However, signs of life emerged in the March quarter, when the number of dividend increases jumped 41% from year-earlier levels. Recent profit growth suggests more good news is in store.
Total profits for companies in the S&P 500 Index surged 206% in the December quarter and are expected to be up 53% for the March quarter. Corporate America has been stockpiling cash, and strong operating results should spark even more companies to boost their payouts in the year ahead.
Dividend growth significantly reduces payback period, the number of years required to recoup your original investment in a stock. A stock that yields 2% with no dividend growth has a dividend payback of 50 years, versus 18 years for a 2% yielder with 10% annual dividend growth.
The table above shows how long it would take investors to recoup their initial investment via dividends, given an initial dividend yield and expected dividend-growth rate. In the table below, we present 20 companies with both solid yields and strong dividend-growth histories. Four are discussed below.
General Dynamics’ ($75; GD) dividend growth has accelerated in recent years. If the dividend continues to rise at an annual rate of 12%, the average over the past decade, investors would recoup their initial investment in 16 years without taking price appreciation into consideration. The company’s recent free-cash-flow growth, widening operating margins, and sturdy balance sheet suggest General Dynamics has the flexibility to keep raising its dividend.
Shares are up 10% this year, outpacing the 5% advance of the S&P 500 Index. Yet the stock still looks cheap at 12 times trailing earnings, 19% below the five-year average. General Dynamics is a Buy and a Long-Term Buy.
IBM ($128; IBM) has paid a dividend without interruption since 1916, and the payout has grown in each of the last 15 years. The quarterly dividend, now $0.65 per share, has more than tripled over the last five years. A modest payout ratio of 25% of trailing earnings suggests IBM has the flexibility to boost the dividend in coming years without sacrificing investment in growth initiatives.
Over the last year, IBM generated $14.32 billion of free cash flow, up 14%, swelling cash stockpiles to $13.98 billion, or $10.90 per share. Takeover activity in the technology industry is heating up, and IBM has been reported to be considering acquisitions of up to $10 billion. IBM said it spent about $1 billion on acquisitions in the March quarter. Cast Iron Systems, a maker of cloud-computing software, was purchased for an undisclosed sum in May. IBM is a Focus List Buy and a Long-Term Buy.
Johnson & Johnson’s ($65; JNJ) dividend, initiated in 1944, has risen every year since 1963. Dividend growth has outpaced earnings-per-share growth over the last 10 years. The dividend payout ratio of 46% is relatively high, but the company still generates sufficient cash to invest in itself.
Generic competition will continue to pressure pharmaceutical sales in the year ahead. J&J’s broad product mix provides some insulation, leaving the company better prepared than most to weather the generic storm.
For the year, Wall Street projects 5% higher earnings per share on 4% revenue growth, targets that could prove conservative. J&J, yielding 3.3%, is a Long-Term Buy.
Should Wal-Mart Stores ($54; WMT) continue the 18% dividend growth it has managed over the past decade, the dividends would pay back investors in 12 years. The quarterly dividend, raised 11% in March, has increased every year since its initiation in 1974.
Wal-Mart has opened fewer of its mammoth Supercenters in recent years, suggesting it may be reaching a saturation point in rural and suburban communities. Now, Wal-Mart is looking to break into major cities using a smaller store format that could include drive-through lanes for shoppers to pick up Web orders. The strategy could help revive U.S. sales, up less than 1% in fiscal 2010 ended January, versus international growth of 11% in constant currency. Wal-Mart is a Long-Term Buy.