“How do I invest in a company whose shares are most likely to appreciate?”
The answer is really the Philosopher’s stone of investing. Therefore, it’s no surprise we frequently field the question (or a variation of it) at Wyatt Research.
In my sphere of the investing universe, which is moored to income, there is one answer. I say that because I know of no better catalyst, no better indicator of future share performance than this – the dividend.
As the dividend goes, so goes the share price.
When speaking or writing about dividends, I lean on High Yield Wealth stalwart McDonald’s (NYSE: MCD) to amplify a point: dividend growth drives share price. McDonald’s is a premier dividend grower. Its annual dividend payout has increased every years since 1976.
As the below graph reveals, the share price invariably trends along with the dividend.
McDonald’s Share Price/Dividend Payout Correlation
The dividend/share-price correlation is apparent from a historical perspective. But investing is about were you’re going, not where you’ve been.
A rational investor is more interested in future dividends, not past dividends. The question then becomes, what variables do I vet to increase the probably of investing in a first-rate dividend grower? After all, a first-rate dividend grower is a first-rate share-price grower.
Cash is the starting point. A company can’t pay a dividend if it lacks cash. So, start with cash flow, operating cash flow in particular. If a company can’t generate cash selling its goods or services, then what’s the point?
McDonald’s continually churns sales into positive cash flow. Recent annual reports – 2012, 2011, 2010 – show the Golden Arch’s operations generated over $6 billion in cash each year by exchanging hamburgers (etc.) into currency units. The dividend in 2012 consumed less than half the annual take, $2.9 billion, of those units.
Debt also matters. A lot of debt consumes a lot of cash in interest and principal payments. A company can generate a lot of cash in its operations, but you don’t want too much of that cash diverted to debt holders. More money used to service debt means less money used to pay dividends to shareholders. I generally prefer a debt-to-equity ratio below 50%. McDonald’s is around 40%.
I also like a dividend-payout ratio that’s 50% or lower. A company that pays less than 50% of its earnings as dividends has wiggle room to grow the dividend.
McDonald’s payout ratio is a little on the high side – falling between 50% and 60%. I give McDonald’s a mulligan here because of its formidable brand and track record. I’m willing to overlook a higher payout ratio.
A formidable brand leads to secure dividend growth. I expect McDonald’s payout to increase year after year at a high single-digit rate. I also expect McDonald’s share price to appreciate at a similar rate.
Single-digit dividend growth combined with single-digit share-price appreciation equals double-digit returns.
McDonald’s is a terrific company and a dependable dividend grower. But finding the next potential dividend grower is what piques my interest.
We added such an investment to the High Yield Wealth portfolio this June. This company generates gobs of cash, and it has no debt. It paid its first dividend in 2012; the dividend consumes less than 30% of earnings. Cash per share is $3.67, which is 15 times more than the annual dividend payout.
We believe this company has the ability to grow its dividend by leaps and bounds. When it does, the share price is sure to follow. Indeed, the share price is already up 40% since our initial recommendation. Such is the influence of dividends, and the expectation for more dividends on a company’s share price.
Are you interested in learning more about this powerful indicator and other share-price catalysts? Tune in this Thursday, February 20, at 2:00 pm ET to an invaluable teleconference hosted by my colleagues Tyler Laundon and Chris Preston titled “100% Returns: A Strategy for Consistent Winners.” Tyler and Chris reveal the catalysts that lead to share-price appreciation (hint: dividend-growth is one). Best of all, the teleconference is FREE. Reserve your spot today.