Wednesday, December 29, 2004

Do the Math

Looking at BankAmerica (BAC) from the perspective of its income alone offers a very clear view of the hidden power of rising dividend investing. Assume you invest $1000 in BankAmerica common stock. Based on BAC's current dividend, it will produce income in the coming year of approximately $38, a yield of 3.8%. In the past decade, BAC's dividend has grown at just over 12% per year. If its dividend continues to grow at this rate over the next ten years, the dividend will grow to just over $118 from our original investment of $1000. Ten per cent growth over the next ten years will result in an ending dividend of $98.50, and 7% growth will result in an ending dividend of $76. These three dividend-growth scenarios all provide solid 10-year ending cash on cash rates of return of 11.8%, 9.85%, and 7.6%. They are not true rates of return in the classical sense, however, first, because these ending dividend amounts take 10 years of dividend growth to reach, and second, because there is no consideration of the ending price of BAC common stock. But working backwards from our expected ending dividends, we can quickly compute the expected range of total returns, considering both time and price changes. To simply matters let's assume BAC's 10-year dividend growth is 7%. We saw earlier that at that rate BAC's dividend would grow from $38 to $76. Still keeping things very simple, let's assume that BAC's ending dividend yield in 10 years is the same as it is today, 3.8%. Using nothing more than fifth-grade math we can now calculate BAC's expected price in 10 years. And if we know that, we can know its expect rate of total return. We can calculate BAC's ending price by dividing its projected ending dividend ($76) by its projected ending dividend yield (3.8%): $76/3.8%= $2000. This calculation shows that our original investment is projected to grow from $1000 to $2000, or 100%. We know that the dividend also grew by 100%, which represented a 7% compounded rate of growth. Because in this example it is BAC's rising dividend that, in effect, pushes up its price, we can take a short cut to the total return calculation. BAC had an initial dividend yield of 3.8% and if we assume that all dividend growth is translated into price growth, BAC's total return is the beginning dividend plus dividend growth: 3.8% + 7% = 10.8% In a world of 3% and 4% bond yields, a projected rate of return from a high quality company of 10.8% is remarkable.