Estimation of Expected Dividend Growth Rate

The expected dividend growth can be defined as the rate at which the common share dividends will grow over a period of time.

In order to determine the expected dividend growth for a given stock, one needs to look at the financial statements of the corporation. The three financial statements are income statement, cash flow statement, and balance sheet. It can surely be argued that cash flow is the only statement that is possibly real while other two statements can be engineered by financial wizards. However, I believe that looking all three together is a prudent approach. In context with dividend growth, my viewpoint about these three statements is discussed below.Income statement is the document which shows past history of corporation’s actions and past performance record. It demonstrates management’s dividend philosophy and strategy vis-à-vis EPS, profitability (gross margins, operating margins), payout factors, dividends, and dividend growth.

  • Profitability, payout factor, and EPS should be closer to corporation’s historical averages and with low standard deviations.

Cash flow is the statement showing current state and how it is able to sustain in present environment. It demonstrates corporation’s ability to generate cash and income from its actual products/services i.e. effectiveness of its continuing operations.

  • The revenue, operating income, and cash flow should have a consistently growing trend. The performance of these parameters will reflect in the growth in dividends.

Balance sheet provides insights into the future of the corporations. It demonstrates how effectively the assets are used and what resources are at its disposal for continued growth.

  • The state of assets and liabilities will show what resources are available at disposal. The constant ratio of liabilities to assets shows that corporation is making effective use of the resources that includes debts (and its availability). Increased liabilities as a function of assets will result in higher cost of debt, financial leverage, and reduced margins.

As a first example, I am looking at JNJ’s financial statement. The relevant extracts is shown in this excel sheet.

  • The revenue, earnings per share, dividends, cash flow, and income are showing consistently growing trends.
  • The gross margins, operating margins, and payout factors are very close to the 10 year average and with a very narrow standard deviation. This demonstrates that management is able to manage its operations very efficiently and effectively.
  • The year-over-year growth rates in dividend and revenue are also close to 10 year average with a tight standard deviation.
  • The operating income and earnings per share are showing a very high variability. A closer look shows that this is likely due to the acquisition of PFE’s healthcare division around that time frame (i.e. 2006 and 2007). It is also reflected in the increase in corporation’s financial leverage and liabilities.

With this analytical information of JNJ, I would anticipate that the future expected dividend growth for JNJ continue to follow its historical trends. My expected dividend growth would be 13.9% with standard deviation of 2.3%.

As a second example, I am looking at KMB’s financial statement. The relevant extracts is shown in this excel sheet.

  • The revenue, earnings per share, cash flow, and operating income is not showing consistent growth. It is more or less a flat trend.
  • While gross margins and operating margins are very close of past 10 year average with narrow standard deviation, these are showing downward trends. The corporation was able to maintain gross margins in 40%s and high 30%s, which is now in low 30%s. Similarly, operating margins is in low teens in last 3 to 4 years as opposed to high teens 6-8 years ago.
  • The payout factor is showing consistent increase from high 30%s and low 40%s to more than 50%s in last three years. This provides an indication that the growth is coming from increased payout factor.
  • A particular cause of concern would be the very high variability in operating income and earnings per share.
  • The corporation’s total liabilities (relative to assets) have also increase significantly from low 60%s to 72%. It has also affected its financial leverage (increased to 72%).

This analytical information of KBM shows quite a few red flags that are likely to affect future dividend growth. Putting this analysis in context of business environment, it can be observed that KMB growth and profitability is under pressure from locally branding products. The flat revenue, EPS, and cash flow trends are the reflection of the fact that demand for its products (personal care, household items, etc.) are stable, albeit not growing. The corporation’s cost cutting measures from 2005 is also not showing positive results in 2006 and 2007, which could be due to higher commodity prices.

KMB’s past 10 year average dividend growth was 8.8% with standard deviation of 4.9%. Assuming that the corporation’s existing trends in profitability and growth continue ‘as is’, I expect dividends will be under pressure. Therefore, with next 5 to 10 year horizon, my expected dividend growth will be 4.6% with standard deviation of 4.5% (this is equal to the average growth in revenue). Another way to look at this would be that, flexibility in payout factors and stability (or growth) in revenue/EPS provides enough room for maintaining the consistency is dividend. At least from my portfolio standpoint and dividend income alone, I would be willing to initiate a starter position. Individuals should look at this from their own risk profile and decide accordingly.

In summary, with next 5 years to 10 years of horizon, my expected dividend growth for JNJ, KMB, GE, PG, and SYY are:

  • JNJ : expected dividend growth – 13.9%; std. dev. – 2.3% (analysis)
  • KMB : expected dividend growth – 4.6%; std. dev. – 4.5% (analysis)
  • GE : expected dividend growth – 5.1%; std. dev. – 35% (analysis) i.e. it could have negative. Is this surprise anymore?
  • PG : expected dividend growth – 12%; std. dev. – 4% (analysis)
  • SYY : expected dividend growth – 9.4%; std. dev. – 3.4% (analysis)

These are only expected dividend growth rates and not stock price growth rates. Individuals should look at this from their own risk profile and investment process.

Disclosure:

At the time of this writing, I am long on JNJ, SYY, PG, and GE.

No position in KMB.

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