Introduction

The first question that someone might ask is "what is a dividend"?  A dividend is usually cash paid to a shareholder.  There are other types of dividends (companies could give more shares, even transfer tangible property to shareholders), but for the purposes of this discussion, we'll stick to cold hard cash.

A press release is normally issued giving details about the dividend and when it will be paid.  For example on October 26 of 2010, AFLAC [NYSE:AFL] issued its third quarter results in a press release.  The release also includes information on the payment of the quarterly dividend.  Such releases contain three key pieces of information:

• The amount of the dividend?in this current example, AFLAC stated that it would pay $0.30 a share to its shareholders
• The date on which the dividend is payable?the third quarter dividend from AFLAC would be paid on December 1, 2010, and
• The record date: the date on which you must be a shareholder to earn this dividend?in the example provided, AFLAC will pay the dividend to shareholders of record at the close of business  on November 17, 2010

These three pieces of information (the amount of the dividend, the payment date and the record date) are provided in press releases from companies.  A third piece of information, the ex-dividend date, is determined elsewhere; this date is the first day on which the shares trade without the dividend.  In the AFLAC example, the ex-dividend date was Monday, November 15, 2010.  People who bought shares of AFLAC on or after November 15 were not entitled to receive payment of the third quarter dividend.  If you owned the shares on Friday, November 12, even if you sold them the next business day, you would receive the third quarter AFLAC dividend.  When you know the record date, the date on which you must be a shareholder of record to earn the dividend is three days earlier: November 14; however, since November 14 was a Sunday, the last date to be a shareholder of record was November 12, a Friday.

Some companies that have steadily increased their dividends

There are many companies that have increased there dividend steadily each year for many years.  The list below, which isn't exhaustive, includes companies that have increased the dividend payment every year since 1980; some of these companies have increased the dividend annually for over fifty years.  The companies are listed in alphabetical order and the list is current as of January 5, 2011.

1. Abbott Labs [NYSE:ABT]
2. Altria Group [NYSE:MO]
3. Archer Daniels Midland Company [NYSE:ADM] 
4. Clorox [NYSE:CLX]
5. Chubb Corporation [NYSE:CB] 
6. Coca Cola [NYSE:KO] 
7. Colgate Palmolive [NYSE:CL]
8. Diebold [NYSE:DBD]
9. Illinois Tool Works [NYSE:ITW]
10. Johnson & Johnson [NYSE:JNJ]
11. McDonald's [NYSE:MCD]
12. Procter & Gamble [NYSE:PG]
13. PepsiCo [NYSE:PEP]
14. RPM International [NYSE:RPM]
15. Sigma-Aldrich [NASDAQ:SIAL]
16. Sysco Corporation [NYSE:SYY]
17. Target [NYSE:TGT]
18. Tootsie Roll [NYSE:TR]
19. Walgreen [NYSE:WAG]
20. Wal-Mart [NYSE:WMT]

Diebold and P&G have increased their dividends steadily for over fifty years; Johnson & Johnson, Colgate-Palmolive, Coca-Cola, Tootsie Roll and even Illinois Tool Works have had over forty years of steady annual growth in the dividend payment.  There's never a guarantee that a company will continue to raise or even pay a dividend; however, once started, such behavior is often anticipated by investors.  The list above is not exhaustive; in fact, over eight companies have increased their dividend payments each year since at least 1980.

The Dividend Yield

Some people buy shares in a company for the dividend alone.  This style is often called investing for income.  Other choices that offer steady income are bonds, a savings account, a certificate of deposit, etc.  A reasonable question becomes if a company is paying shareholders a dividend of $0.30 each share every quarter, what's a reasonable price to pay per share so that I can capture that cash flow?  There are some other factors that such a person might consider, for example, how safe is that dividend?  Can I be reasonably assured that the company will continue to pay that dividend into the future?  Finally, does the dividend increase over time?

If you think there's a small chance that the dividend could drop or even disappear, you might consider paying a much lower price to own the company.  If you're convinced that dividend payments will increase regularly, you may be willing to pay more.  We'll talk about these points later.

One key piece of information that an investor needs is something referred to as the "dividend yield."  The dividend yield is the share price dividend into the current annual dividend.  It provides a measure of the rate of return.  So, if you perform this calculation and get an answer of 1%, it means that, based on the dividend payment alone, you're return is a paltry one percent each year.  It may not make sense to buy a company for the dividend alone; however, if you (i) suspect that the dividend payment will increase steadily and/or (ii) that the share price will continue to grow, even a small yield may be part of an attractive investment.

Let's say a company has a very generous dividend.  Generous is measure by the "yield," which is the annual dividend divided by the stock price.  A low yield implies a low rate of return based on dividends alone, while a large yield (and 5% is a large dividend yield) implies a high rate of return.  Of course, the stock price can appreciate too?and for most dividend paying companies it does?so not only can one get price appreciation, one can also get paid a cash dividend.

How Expectations Influence What You Might Pay

Investors have choices about where to put their money.  The first thing to think about is what are your other options.  If your current portfolio is returning 3% annually and you're quite happy with that return, then an investment that returns 5% each year mightn't look too bad.  If you're expectations are higher, say you require an annualized return of 15% from your portfolio, then you have much higher demands.

Let’s say you have an investment that pays a steady, fixed amount each year forever!  It doesn’t matter what it is: a dividend, some type of interest from a financial instrument or an annuity.  We'll call this the Cash Stream example.  Let’s say that payment from this instrument is $1.50 each year.  As mentioned above, people have different expectations of an acceptable rate of return.  To attach a value this stream of payments, you divide the periodic payment (the $1.50 a year in this example) by the rate of return expected by the investor.  So, with a payment of $1.50 and a expectation of earning 5% annual yield, the investment would be valued as follows:

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So, a person who finds a 5% (.05) annual return acceptable would value this financial instrument at $30.  If your expectation is 15%, you’d value the investment at $10; it’s what you’d be willing to pay to own this regular flow of cash.  Your acceptable price is lower because you have a higher expectation on the yield or return: 15% versus the first example of just 5%.  The simple equation is generalized as follows:

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If you think that the dividend might not increase as rapidly in the future or that it might even be cut, a savvy investor that normally requires 5% might make even bigger demands and increase this or her required return to 20%.  In this case, a price of $30 that once seemed reasonable would fall to $7.50 ($1.50 ÷ 0.20 = $7.50).  In times of higher inflation, investors that once required a 5% return would increase that figure and finding a lower purchase price as acceptable from dividend paying assets.  It's normal to see knowledgeable buyers demand a lower price when they believe that there are risks associated with the asset that they are interested in purchasing.

An Example of Dividend Yield: Merck & Company 

A few years ago, pharmaceutical giant Merck & Company [NYSE:MRK] had a stock price so low that the dividend yield reached 5%.  Merck had a long history of dividend payments stretching back about forty years.  While the dividend wasn't increased each year, it grew over time and was never cut.  Many people believed that the dividend was safe and that it was unlikely to be reduced or eliminated.  The question becomes, if buying the stock for dividends alone and assuming that the current dividend payment would continue to grow into the future, what is that stock worth?

Well, you could start off by applying the concept described above.  Find out what the annual dividend is, then divide that figure by the return you require.  The big question is how do you account for the fact that you believe that the size of that dividend will continue to grow in future periods?  This issue is addressed by the dividend discount model.

The Dividend Discount Model

The Dividend Discount Model starts to address some of the issues raised in the discussion above.  First off, we know that for many good companies, the dividend grows over time.  (In the example of the asset paying $1.50, there was an assumption that this payment never changed from year to year.)  If you have a rate of return that you require of your investments, an example of a meager 5% was used above, and you also know the average annual growth rate for the dividend, you can modify the simple relationship described early and come up with the Dividend Discount Model.  Here it is

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You've just reduced your required annual growth rate by the contribution made by the growing dividend.  The dividend growth lowers your hurdle for an acceptable rate of return.  As we saw earlier, all else being equal, this lower effective required rate means that you'd likely be willing to pay a higher price for a growing company than you would from an otherwise comparable company that lacks the same dividend growth.

For most investors here on Zecco a return of 5% a year wouldn't be acceptable.  Some have suggested 100% a year would nice?while I agree, we'll look at what this expectation does to prices in a moment.  Let's say that we expect an average return of 15% each year for our portfolio.  We'll use this hurdle rate or required rate of return in later examples.

The dividend discount model uses three things:

1. it uses the periodic payment?which is the current annual dividend;
2. it uses the rate of return that you the investor require (we're saying 15% in this example), and
3. it uses the anticipated future growth of those dividends.

To use the Dividend Discount Model, you subtract the expected growth rate of the annual dividend payment from your expected return and divide this difference into the current annual payment. 

Let's think about this concept and run over it one more time.  In the Cash Stream example, if a knowledgeable investor thought those annual payments were imperiled he or she would have raised the bar and demanded an even bigger potential return: initially, when all seemed well, that person would have settled for 5%.  When the payments are under threat, it was raised to 20%.  This increase in expected returns results in a lower acceptable price for the asset producing the $1.50 a year.  Think of another twist: let's say the knowledgeable investor discovered that the annual payment was actually going to increase each year for the foreseeable future.  Under those circumstances, this investor may lower the threshold for an acceptable return from 5% to a lower number.  That's what dividend growth does in the express above; it changes the hurdle rate.  This action would raise the price that the investor would be willing to pay for the asset.

When an investor expects dividends to grow over time, all else being equals, it raises what he or she considers is a fair price for the company.  If the dividend is likely to decline, it lowers that acceptable price.

Regardless of the return demanded by investors and the anticipated growth rate of future dividends, the model must be used judiciously.  For example, the anticipated dividend growth rate can never be higher or the same as  the required rate of return; if it is, the results are meaningless.

The Dividend Discount Model brought to you by Kellogg 

Let's look at another company, Kellogg Company [NYSE:K], famous for its breakfast products.  The 2010 dividend will be $1.56 per share.  In fact, Kellogg has a history of steady increase in payments for over fifty years.  It doesn't increase the dividend every year, but it never reduces it.  In 1960 (slit adjusted) the annual dividend was $0.02; by 2010 it had reached $1.56, so the dividend growth compounded at an impressive rate of 9.1% per year.  On January 5, 2011, shares of Kellogg closed at $51.07 each.  So let's say you're a knowledgeable investor with a requirement of a 15% from anything you own.  If you accept that the dividends will continue to grow at 9.1% for the foreseeable future, then a price you would find acceptable to capture the future stream of dividends is $26.44.  Since this price is much lower than the price required by the market, you might not find such an investment attractive.

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Let's say that you have a conservative streak and out of an abundance of caution, you throttle back on future dividend growth.  If instead of the historical compounded rate of 9.1%, you believed that 6.5% was more acceptable, then the acceptable price for Kellogg would be $18.35.  On the date of the calculation, the market price of $51.07 is much higher than would be acceptable to an investor with the requirements detailed in this paragraph.

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Neither of these two acceptable prices calculated above is close to the lowest price achieved by Kellogg in the last year; that price was $47.28; however, the dividend discount model looks at dividends alone and doesn't include likely stock price appreciation.  If you expect the stock price to increase too, then the return from dividends fills just part of your requirement.  Inclusion of stock price appreciation is the topic of another blog.

If you're happy with an annual return of 12% from each of your investment assets and you accept that 9.1% is a reasonable growth rate for the stream of future dividends, you'd conclude that a fair price at which to acquire Kellogg is $53.79.  As discussed earlier, if the stock closed at a price of $51.07, lower than your acceptable price, you might consider Kellogg to be at an attractive price to add to your portfolio.

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Note that the price at which you would find an asset attractive using only the dividend discount model involves the following:

• A hurdle that you stipulate which your investment must reach; this hurdle is an annual rate of return that your investment must provide;
• A current dividend or other payment and an expectation that these payments will continue into the future; and
• If the level of payment is likely to increase over time, knowledge about what that annual rate of increase could be.

I stress the word only, because other factors should be used in the buying decision.  The dividend discount model provides just a single point of information on the attractiveness of a company stock.

Including anticipated inflation 

Let's say you believe higher inflation will be a problem in the future.  If you know your required rate of return and you're happy with the assume growth rate for the dividend stream, you can also include inflation into the mix.  Whatever annual rate of inflation you anticipate, simply increase your hurdle?your required return?by that amount.  If you're happy with a return of 10%, but you think that the rate of inflation could jump to 8% over the coming years, your new rate of return becomes 18%.

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Increasing your required rate of return by adding a component to cover anticipated inflation lowers the price at which you'd find the investment attractive.

The model has limitations

The model has limitations.  The dividend may not be stable and it's challenging to know how to include such erratic behavior into the model.  The model also gives unrealistic valuations if the required rate of return is very low; you could end up with the bizarre scenario that any price or even a negative price is acceptable to buy shares of the company; the model has to be used with judgment.   It also doesn’t account for the fact that a company with a low dividend yield is likely to attract fewer investors than a firm with a high yield.

Does this model make sense? 

You can skip this subsection and come back to it later if you'd like!  I want to touch on the topic of discounting cash flows or payments.  I think it's something that people intuitively grasp, except if it's presented in its raw mathematical form, a form that seems to trigger an immune response with most audiences.

If I asked you would you rather have $100 today or one year from now, most rational investors would accept the money today.  If I asked you would you prefer $100 today or $1 billion a year from now, most rational investors would likely think, wait, there's some kind of catch, what's he up to.  If they're convinced it's a real choice, they'd select $1 billion in twelve months.  Things get trickier if the choice is between $100 today and $150 in a year.  If you're convinced that you can do something to make $100 worth more to you today than would $150 a year from now, you'd take that $100.  You might be convinced that you could invest it and earn and extra $50.  In your head, you're essentially discounting back.  Most people would likely take $100 today instead of waiting to get $101 in a year.  It gets even tougher if the option is $100 or $50 a year from now and another $75 a year after that.  The dividend discount model, described earlier, is doing that math based on the requirement that the investor get a 12% return in the last example above.

So, when you look at the last example, the example where the required return was 12%, you might be thinking who in their right mind would pay $51.07 to receive a dividend of $1.70 in 2011? Getting $100 or $200 a year from now, that's obvious, but paying $51 today to get $1.70 this year and another payment next year, hmm.  (Note the 2010 dividend is $1.56 and it is anticipated to growth by 9.1% in 2011?I wonder will that happen!). 

Once you delve into the question, you discover more about the mechanics of the model and, frankly, its limitations.  For example, if the person is still alive one hundred years from 2011, the stock will generate a dividend of around $10,314 in that year.  Suffice it to say that, while the dividend in 2111 might be $10,314, the shareholder has an expectation that the investment returns 12% a year, so this number is discounted back every year for 100 years to find out what the figure is worth to the investor today. It turns out that $10,314 in 2111 has a value of just under $0.10 today!  In other words, if you want an investment to return 12% every year, if it gives you $10,314 dollars a hundred years from now, that princely sum is worth almost a dime to you today.

You've already decided that you can require 12% a year, so if you invested 10 cents in early 2011, it would compound to $10,314 in 2111: nice and symmetrical.  Around 10 cents invested at 12% for a hundred years mushrooms to $10,314 or thereabouts in 2111.  A figure of $10,314 in 2111 is worth slightly less than $0.10 in 2010 to someone requiring a return of 12% annually from their investments.

If you were to add up each of the annual dividend payments from Kellogg for the next hundred years, you'd come up with a figure of over $113,000!  (Keep in mind, you're assuming that the dividend payment will continue to grow at 9.1% a year each year.)  When you discount each of those dividend payments back at 12% a year, that is, you ask yourself what would I pay today to own the dividend in some far of year; you then add all those dividends, year-by-year, that have been discounted back to what each of them is worth to you today, you end up with that figure of just over $53 discussed in the previous subsection.

There are ways to modify the model to account for changes in dividends at different times, irregular dividend payments, but we're not going to get into that point in this discussion.  This issue of discounting cash flows will be discussed in a later blog when the concept of free cash flow thrown off by a company is discussed.

Another example 

On January 5, 2011, AFLAC [NYSE:AFL] closed at a price of $56.38.  The company paid a dividend in 2010 of $1.14 per share; this dividend has grown steadily over the past twenty-five years at a rate of about 11%.  If an investor had a hurdle or required return of 15% for his or her investments, at what price would an income investor start to feel happy about purchasing this company?  If the return were 12%, would the price on January 5, 2011 appear attractive?

Summary

The dividend discount model provides insight into what an knowledgeable investor would consider a fair price for a dividend paying stock. The model provides a purchase price based on expectations of growth in future dividend payments and the annual rate of return required by the investor.  The dividend discount model has limitations, not least of which are assumptions that the growth in dividends will increase unabated and that the company will exist forever; the model can be modified to minimize some unrealistic expectations.  As it stands the model should be applied judiciously and in concert with other criteria to be used in selecting a suitable stock. In a later blog, this model will be incorporated into a more comprehensive tool called the Stock Selection Guide.

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