Investing in dividend growth stocks is not about buying a current high yield, but instead building a high yield-on-cost over time. One of the criticisms I am hearing more often is, “That low yield isn’t even covering inflation.” This is a very valid concern, if true. To test this criticism, I built a model it and ran several dividend stocks through it. The results just might surprise you…
First, let’s look at inflation, specifically the consumer price index for all urban consumers (CPI-U). I chose this index since it focuses on a typical market basket of goods and services consumed by all urban consumers. In the August 2010 Budget and Economic Outlook, published by the Congressional Budget Office (CBO), it offers a very mild outlook for inflation. The CBO is projecting the CPI-U for 2010 to be 1.6%, 1.0% in 2011, 1.7% in 2012-2014 and 2.3% 2015-2020.
The mild inflation could be the result of a slow recovery. As for economic growth the CBO offered this:
In the past, many recoveries from deep recessions have been quite robust. After deferring purchases during a slump (especially for expensive goods like homes, automobiles, and capital equipment), households and businesses typically boost their spending quickly as economic prospects improve. However, international experience suggests that recoveries from recessions that were spurred by financial crises tend to be slower than average—perhaps because the losses in wealth and damage to the financial system that occur during such crises weigh on spending for a number of years. Following such a crisis, it takes time for consumers to rebuild their wealth, for financial institutions to restore their capital bases, and for nonfinancial firms to regain the confidence required to invest in new plant and equipment; all of those forces tend to restrain spending. In addition, under current law, both the waning of fiscal stimulus and the scheduled increases in taxes will temporarily subtract from growth, especially in 2011.
With the above back-drop, I created an Excel model to compare a dividend growth stock to inflation. The model is simple to use. It has the following inputs:
Symbol: The dividend growth stock’s ticker symbol
Current Year: This year (2010)
Current Yield: The dividend growth stock’s current yield
Dividend Growth: The dividend growth stock’s estimated dividend growth rate
Inflation Rate: Estimated inflation rate
The Interpretative Analysis section calculates the net present value (NPV) of the annual differential between the dividend income investment and inflation (discounted at the inflation rate). The break-even button next to the Inflation Rate input field will calculate the inflation rate where the dividend stock investment equals inflation. Let’s run some numbers:
|Caseys, Inc. (CASY)||–||0.92%||15.47%||4.36%|
|ADM Co. (ADM)||–||1.77%||7.41%||3.57%|
|Wal-Mart Stores (WMT)||Link||2.33%||11.01%||6.57%|
|General Dynamics (GD)||Link||2.68%||10.07%||6.84%|
|Exxon Corp. (XOM)||–||2.84%||4.82%||4.39%|
|Piedmont Nat. Gas (PNY)||Link||4.00%||3.74%||5.55%|
It is interesting to note that just a little dividend growth goes a long ways. One other consideration is taxes. To run the calculations on an after tax basis, simple enter the dividend yield on an after-tax basis. For example, if the dividend yield is 4% on a pretax basis and your marginal tax rate is 30%, then enter 2.8% as the dividend yield (4% x (100%-30%)).
You can download D4L-Inflation.xls and be prepared for the next time someone tells you that dividend stock is not even covering inflation. Just ask them what is their projected inflation rate and the stocks projected dividend growth rate.
Full Disclosure: Long WMT, GD, CL, KO, JNJ, KMB. See a list of all my income holdings here.
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