Sunday, November 15, 2009

The Hidden Power of Rising Dividends

I have written and spoken about the Hidden Power of Rising Dividends compared to bonds for nearly 20 years. Yet, I find that many people do not grasp and retain the concept. The primary reason for this is that most people think of stocks as investments you trade and bonds as investments that you hold to maturity. If you would think of stocks as more like bonds, however, a new vision of the power of stocks as income producers comes into view. For example, let's compare Johnson and Johnson (JNJ) common stock with a 10-year US Treasury bond. Today the dividend yield of JNJ is 3.2% (1.96/62) compared with the yield on a 10-year T-bond of 3.4%. On the surface, from an income perspective, the T-bond would seem to offer a better deal. It is AAA rated, it is an obligation of the full faith and credit of the United States, and it offers a modestly higher yield than does JNJ's common stock. Yet, if a person is looking for safe and secure income, I would argue that JNJ common stock might be a better investment than the US T-bond. Here are a few reasons: JNJ's bonds are also rated AAA, one of only six or so companies in the world with such a rating. This strong credit rating for JNJ means that it has the financial strength to endure about anything that may come along over the next 10 years. Next, JNJ common stock has paid a dividend since 1944 and has raised its dividend for 46 consecutive years. Over the past 20 years, JNJ has increased its dividend by an average of about 14% per year. If JNJ were to continue hiking it dividend at 14% per annum, its dividend would nearly quadruple over the next 10 years. In light of pressures in the health-care industry, we do not believe they can maintain the 14% dividend growth, thus, for simplicity sake, let's assume JNJ's dividend grows at about 7.2% per year. At that rate of growth, its dividend will double over the next 10 years. Starting with today's dividend of 1.96, a 7.2% growth rate would produce the following annual dividends for a share of JNJ stock:
  1. 2.10
  2. 2.25
  3. 2.41
  4. 2.59
  5. 2.77
  6. 2.97
  7. 3.19
  8. 3.42
  9. 3.66
  10. 3.93

Now comes the part that most people miss. Our dividend yield ten years from now will be the then current dividend divided by our purchase price. Today JNJ is selling for $62 per share. Thus, based on today's price, if JNJ does increase its dividend at a 7.2% rate over the next decade the yield on today's price would be 3.93/62=6.33%.

So does it mean that we will make a cash on cash yield of 6.33% if we hold JNJ for the next decade? No, it won't be quite that good. You have to remember that it will take 10 years to produce the 6.33% dividend yield. To find the precise rate of return would require doing an internal rate of return calculation. We can, however, do a simple calculation that will give us a good idea of what we will make for JNJ over the next decade. If we average the starting and ending dividend yields, we'll achieve a ball park idea of the cash on cash return over the next 10 years. (3.20%+6.33%)/2= 4.77%.

So when we compare JNJ common stock with a 10-year T-bond, we should take into consideration that JNJ's dividend income will grow, while the income from the T-bond will be static.

There is certainly risk that JNJ won't hike it dividend by our projected rate, but I would argue that there is just as much of a chance that the dividend growth will be higher than our example. So for my money, JNJ, as a pure income investment, will provide a better return over the next decade than a T-bond just from the dividends alone.

However, as they say on late night TV, "But wait, there's more!" JNJ is not only an income security, it is an equity security. Therefore it's price will fluctuate over the next 10 years along with its prospects. At first that might swing your investment choice back to the bond. But consider the following, if JNJ's current 3.2% dividend yield is still in effect 10 years from now, and its dividend has, indeed, doubled, then its price will also double to near $124 per share. The computation for this is straight forward: ending dividend (3.93) divided by ending dividend yield (3.2%). If that is the case, then our total return for the period would approximate 10.5% per annum.

I realize there are a lot of moving parts in this discussion and that may make your eyes roll back in your head. Believe me, however, it is worth your time to get your mind around the simple math that is the basis of the Hidden Power of Rising Dividends.

We have owned the stock for many years. Do not buy it because we own it. This blog is for information purposes only.