I doubt you’ll find many bigger cheerleaders out there for the dividend growth investing strategy than me.
After all, I’ve doggedly lived below my means and invested my excess capital into high-quality dividend growth stocks for six years now, amassing a six-figure portfolio that’s set to generate more than $10,000 in dividend income for me this year.
Dividend growth stocks are stocks that routinely and regularly pay and increase dividends to shareholders.
And a dividend itself is funded by the profit a company generates.
[ad#Google Adsense 336×280-IA]So when you see a company out there that’s been able to increase its dividend for 20 or 30 or 40 (or more) consecutive years, you can likely surmise that underlying profit has been more or less moving in an upward direction over that same stretch.
Not just any company can grow its profit (and dividend) for decades on end.
It takes a special kind of business to be able to do that; it’s going to be one that provides products and/or services that other people and/or other businesses demand regularly.
You can see exactly what kind of businesses have the right competitive advantages and business models to be able to do this by checking out David Fish’s Dividend Champions, Contenders, and Challengers list.
Mr. Fish’s resource is incredible because it distills the thousands of publicly traded stocks out there into just those that have increased their dividends for at least the last five consecutive years.
Dividend income is a wonderful source of passive income – my personal dividend income (as noted earlier) covers most of my personal core expenses (with other passive income making up the difference).
But growing dividend income is far better, and these dividend growth stocks provide organic passive income growth via the dividend increases the companies routinely announce.
Like I said, I’m a huge (and unabashed) cheerleader.
But that doesn’t mean I think one should just go out and buy any dividend growth stock at random and then go and pay any price being asked.
That’s just plain silly.
Specifically, one should aim to avoid overpaying for dividend growth stocks.
Overpaying is when you go out and knowingly pay more than what a stock is reasonably worth.
See, the price you pay may not (and probably won’t) necessarily correlate very well to what a stock is actually worth.
Price is simply what you pay.
But value is what you’re getting for your money in exchange; value is worth.
How, then, does one differentiate the two?
Well, taking the time to ascertain a reasonable estimate of what a stock is actually worth is the first thing you have to do.
Can’t know whether or not the price is appropriate without first knowing what you’re getting.
Fortunately, the Internet has radically changed the game, making it much easier than ever before for even an average retail investor to get a good idea of what just about any dividend growth stock is likely worth.
The proliferation of resources now available for just this one task is incredible.
And you don’t have to go very far to find one great resource – fellow contributor Dave Van Knapp put together a great guide to valuing dividend growth stocks not long ago, and it’s an excellent template that’s easy to follow.
Overvalued dividend growth stocks should be avoided for a number of reasons.
First, your income will likely suffer.
All else equal, price and yield move against one another; they’re inversely correlated.
That means the more you pay, the lower your yield will be (assuming no change to the dividend).
And this lower yield will also affect your future dividend income in two aspects.
Your aggregate income is lower right from the start since the lower yield means less current income, which, of course, affects the total income prospects of the investment over the long run.
In addition, all future dividend increases will also then be based off of a lower yield, negatively impacting your aggregate income, too.
Second, your potential long-term total return is lowered.
You see the potential dragged down by the lower yield right off the bat since yield is a major part of one’s total return.
And capital gain is also hampered by the very virtue of the downside that exists in the space between the higher price you paid and the lower amount the stock is actually worth.
That gap could easily close if the market realizes the overvaluation that is present, sapping away your capital in the process.
Third, you amplify your risk.
Is it more risky to pay $50 for a stock likely worth $40 or $40 for that same stock?
Case closed.
You add downside risk when you over pay while simultaneously limiting your possible upside.
The broader market is within a few points of its all-time high right now.
As such, it should be no surprise that many stocks are also near or at all-time highs.
One high-quality dividend growth stock is indeed near its all-time high.
It’s a great stock with a great business model. I should know – I’m a shareholder.
However, it does appear to be overvalued right now…
McDonald’s Corporation (MCD) operates and franchises the largest fast-food restaurant chain in the world, with over 36,000 restaurants across 125 countries. Over 30,000 of these restaurants are franchise/affiliate units.
One of the most well-known brands in the world, the business model is predicated on simplicity, speed, value, and consistency: McDonald’s serves up cheeseburgers, fries, shakes, and other food products consistently and quickly at a low price point.
And they’ve done incredibly well, becoming a ~$112 billion behemoth.
What’s perhaps less well-known to casual observers is that the company’s stock is a premier dividend growth stock.
They’ve increased their dividend for 40 consecutive years, a track record that’s unmatched in this particular industry.
It’s difficult for any business to increase its dividend for four straight decades, but this industry can be particularly fickle with consumers’ changing tastes and preferences. Moreover, increased competition both here in the US and abroad has become a major challenge.
But McDonald’s is still incredibly profitable and very massive, and they’re still increasing their dividend.
And increase it they have: The 10-year dividend growth rate is a monstrous 17.8%.
I’m not sure what tastes better, a Big Mac or a 17.8% dividend growth rate.
Before we get too excited, though, we have to consider that the company’s dividend growth has slowed markedly over the last few years. The five-year dividend growth rate is about half that mark, at 8.8%. And the most recent dividend increase was even lower, coming in at less than 5%.
This lower dividend growth rate is likely a “new normal” for the foreseeable future since the payout ratio is 68.6%.
While not alarming, that’s on the high side. It’s also notably higher than it was a decade ago, meaning the dividend has simply grown faster than underlying profit on a per-share basis (as we’ll see in a moment).
Simply put, the payout ratio can’t really be expanded much anymore. So the dividend will have to grow more or less in line with earnings per share from here on out, and perhaps even slightly slower in the near term so as to lower that payout ratio back down a more comfortable level.
The good news, though, is that the yield is really attractive right now.
At 2.78%, that’s quite a bit higher than the broader market. And it’s certainly much greater than what you’d get by putting your money in the bank.
However, that yield trails the stock’s own five-year average of 3.1%, which is a spread of more than 30 basis points.
So we can see how buying now puts one at a disadvantage in terms of the income both now and in the future relative to what’s been typically available, on average, over the last five years.
Not only that, but the yield has been higher in the past while the dividend growth was also a bit higher.
The stock not only features a lower-than-average yield now but also dividend growth that is likely to be stunted for the foreseeable future.
The dividend, overall, offers a lot to like and some things to perhaps not be terribly excited about.
The 40-year dividend growth track record is pretty amazing. And I fully expect the company to continue increasing its dividend for both the short term and long term.
But the yield is lower than it’s average over the last five years. And the payout ratio is elevated.
Let’s next take a look at the company’s underlying top-line and bottom-line growth over the last decade. We’ll then look at a forecast for near-term EPS growth.
This will tell us where the company’s been and where it’s likely to go, which will help us value the business and its stock.
McDonald’s grew its revenue from $21.586 billion to $25.413 billion from fiscal years 2006 to 2015. That’s a compound annual growth rate of 1.83%.
Meanwhile, the company increased its earnings per share from $2.83 to $4.80 over this period, which is a CAGR of 6.05%.
We can now see why the payout ratio is higher than a decade ago – EPS growth has not nearly kept up with dividend growth, causing the slowdown we see with some recent dividend increases.
Substantial share repurchases have helped propel some of that excess bottom-line growth, with the company reducing its outstanding share count down by approximately 25% over this stretch.
Looking forward, S&P Capital IQ believes McDonald’s will be able to accelerate its EPS growth a bit over the near term, forecasting 10% compound annual growth for McDonald’s earnings per share over the next three years.
S&P Capital IQ cites the restructuring that McDonald’s is currently undergoing as a main catalyst for this – McDonald’s plans to refranchise about 4,000 restaurants by 2018, reducing the risk of directly running restaurants on a day-to-day basis, making the company more of a direct franchise business model with the associated franchise fees.
In addition, the newly introduced all-day breakfast initiative has boosted recent results for McDonald’s, and this could be a long-term game changer.
This forecast could be moderated by the strong dollar, rising labor costs, any input issues (food supplier scandals, rising input costs), and waning demand for the all-day breakfast foods. Overall, it seems like an aggressive forecast, but it’s certainly not outside the realm of possibility for the firm.
Another area of the business that has deteriorated somewhat over the last few years (in addition to the aforementioned dividend growth) is the balance sheet.
Those substantial share repurchases have to be funded somehow, and McDonald’s has taken on a lot of long-term debt to retire those shares. An argument can certainly be made that it makes sense to take on cheap debt (due to low rates) to retire expensive equity, but the balance sheet has been stretched a bit.
The long-term debt/equity ratio is 3.40, while the interest coverage ratio is just over 11.
Long-term debt has tripled over the last 10 years (from over $8 billion to over $24 billion); however, the balance sheet does look a bit worse than it really is due to the low common equity (McDonald’s retains a lot of treasury stock on the balance sheet).
Profitability, meanwhile, is very robust, especially in the margin department.
Over the last five years, the firm has averaged net margin of 19.05% and return on equity of 37.77% (boosted by the leverage and low common equity).
McDonald’s strikes me as a great long-term investment.
People have to eat, and providing quality food that tastes good at a low price point and in a quick manner is a recipe for success, as the company has demonstrated for decades on end. Even with increased competition and a big change in consumers’ health awareness and changing dietary choices, McDonald’s still dominates.
However, the company isn’t quite as strong today as it was a decade ago, in my view.
Moreover, the stock appears to be overpriced…
The P/E ratio is sitting at 24.63 right now, which is awfully high for a company growing in the mid-single digits. That ratio is also much higher than the broader market. We also know the yield is lower than it’s averaged over the last five years. And investors are also paying much more for cash flow than they’ve paid, on average, over the last five years.
What, then, would be a fair price to pay? What’s the stock reasonably and likely worth?
I valued shares using a dividend discount model analysis with a 10% discount rate and a long-term dividend growth rate of 6.5%, in line with the 10-year EPS growth rate. The recent dividend increases and high payout ratio perhaps makes this model a bit aggressive, but I’m also factoring in the forecast for near-term EPS growth and some recent EPS growth acceleration. The DDM analysis gives me a fair value of $108.33.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today. I find it to be a fairly accurate way to value dividend growth stocks.
I just don’t see a margin of safety on the stock right now. Quite the contrary, it looks expensive. But am I the only one with that viewpoint?
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates MCD as a 3-star stock, with a fair value estimate of $130.00.
S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
S&P Capital IQ rates MCD as a 4-star “buy”, with a fair value calculation of $104.60.
Not sure why the latter firm recommends the stock even while they view it as overvalued, but even the higher valuation estimate from Morningstar shows no margin of safety. I like to average these three valuation estimates together, which should improve accuracy by blending these different methodologies together. That final valuation is $114.31, which means this stock looks 11% overvalued right now.
Bottom line: McDonald’s Corporation (MCD) is a global juggernaut operating a simple and fantastic business model. The dividend growth track record is among the best. However, the stock is up almost 30% over the last year after the excitement of all-day breakfast took hold. That’s put the stock in what looks like overvalued territory, with the possibility of 11% downside on top of a lower-than-average yield. I’d recommend waiting for at least a 10% pullback before considering this name.
— Jason Fieber
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