Investors do not have many choices when looking for income today. Aside from vehicles like annuities, the only place for income is dividend stocks. The dividends will increase with inflation and the stock price will appreciate over time. And many dividend stocks pay more income than the 10-year bond! This is how I like to look at dividend stocks – what I will earn over the next 10 years.
You may ask why I take the long-term outlook. There are many variables affecting the markets that I can’t control or even predict such a significant financial crash (dot com crash, housing bubble, etc.) or market correction. However, if you are in the right stocks you will still earn dividend income and make money over the long-term.
In the U.S., S&P 500 dividends last year were 55% higher than in 2007, the peak of the last cycle, while earnings were up only 29%. Dividends over the past five years have grown at an annualized 13%. Look beyond the recent past and dividends have been vital to long-run returns. Indeed, U.S. shares were worth the same in July 1982 as in June 1901, adjusted for inflation, according to data compiled by Prof. Robert Shiller of Yale. All returns that topped inflation over that period came from reinvesting dividends. Their power is well known: An investor who bought U.S. shares in 1900 has made 2.1% a year in capital, but a total of 6.4% a year once dividends were reinvested, according to Elroy Dimson, Paul Marsh and Mike Staunton of London Business School.
While dividends are an important component to stock returns, I don’t think they are priced into all dividend stocks to reflect their true value. Here is a good example. Income investors will flock to a stock like Altria Group (MO), the tobacco stock, because it is known as a good dividend stock. MO trades around $65 and has a dividend yield of 3.5% so it is interesting as a income purchase. MO already pays out 74% of its earnings as dividends so there is no upside in the dividend payout ratio. EPS are projected to grow at 8% per year so there is upside to increased dividends. However, the forward P/E ratio is at 21 so the stock is priced high due to its income potential. According to my proprietary stock valuation model, MO should be priced near $60 so some of the future growth is already priced in the stock. I will only buy Altria on a pullback below this level.
The income investor should have a blend of stocks producing high income today and some that will continue to growth their dividends in the future. Altria produces income today! Take a stock like Expedia (EXPE), online travel stock, that has a current dividend yield of 1% while trading at $111 per share. Not a stock that an income investor would look to for dividends. However, if you look forward 10 years, EXPE may produce a dividend yield on cost near 15%. How is this possible? Simply because EXPE is projected to grow EPS by over 20% per year in the coming years. And its current dividend payout ratio is only 20%. If the EPS materialize and the payout ratio hits 50% in 10 years, then you can earn a 15% yield based on the current market price of Expedia. In case you are wondering, EXPE is significantly underpriced today based on its future growth rate as it has a forward PEG of 0.83.
Where can you buy a potential 15% yield today? For investors looking for future income, they should add some dividend income and growth stocks to their portfolio.