How to Estimate the Future Return from a Dividend Growth Stock
Discounted cash flow (DCF) is a widely-used method for stock valuation. It involves estimating the future cash flows of a company and discounting them back to the present to account for the time value of money. Fortunately, there is a much simpler method that can be used to estimate the future return from a dividend growth stock. In this post, I will explain the logic behind the method and provide a recent example where I applied the method before adding to two stock holdings.
Investors have two sources of returns from dividend growth stocks – dividends paid and capital (price) appreciation. Company management decides on the dividends to be paid after careful consideration of its financial condition. Dividend growth tends to follow a company’s increasing revenue and earnings. Capital appreciation occurs over time in response to increases in the dividend paid by the company. This statement is self-evident when you observe that the dividend yield of a mature company tends to fluctuate around a fairly stable average yield over long periods of time. Many investors don’t understand this because the dividend yield also fluctuates due to capital appreciation/depreciation that occurs as investors collectively decide to pay more/less for a dollar of earnings. This price/earnings ratio adjustment, denoted by (P/E)adj, tends to increase during bull markets and fall during bear markets for most stocks.
In mathematical terms, the expected return equation is: Expected Return = Current Div. Yield + Future Div. Growth + (P/E)adj
The first two terms on the righthand side of the equation, Current Div. Yield + Future Div. Growth, reflect the operating performance of the company under investigation. This dividend growth metric was identified by Seeking Alpha author Chowder and is often referred to as the Chowder Number. Higher numbers tend to reflect better operating performance.
Utility stocks in Canada often offer a relatively high Current Div. Yield, but relatively low Future Div. Growth. I try to purchase shares in regulated utilities when their Chowder Number is around 10 because their earnings are relatively dependable. For faster growing stocks, I really like to see a Current Div. Yield in the 1-3% range and a Chowder Number of at least 12 before I investigate the company seriously. Buying faster growing stocks with a Chowder Number of 12 provides a margin of safety relative to my minimum target investment return of 10%. Chowder proposed slightly different rules than the ones I use, but the concept is similar.
The third term of the equation, (P/E)adj, reflects the current valuation that the stock market places on the company. When the company is trading at a discount to its long-term average (P/E), the investor can often expect the (P/E)adj will be a positive quantity in expectation that the company will revert to its average value over time. Likewise, it is often a good time to buy a stock when its Current Div. Yield is above its long-term average and near the top of its historical range. Investors can use shortcuts like these for companies that they understand well, such as a company they have owned for years.
Investing is challenging for a number of reasons. Firstly, the investor has to be aware that there is always significant uncertainty associated with predicting the future prospects of any company. This is why it is important to have a margin of safety when you buy stocks. Secondly, the investor needs to be aware that lower-quality companies sometimes make financial decisions that are unsustainable in the longer term, which usually leads to an unpleasant surprise down the road. Thirdly, lower-quality companies are usually afforded lower valuations by the stock market, which entices investors to buy them over higher-quality competitors. Lastly, the market often exhibits irrational exuberance in valuing fast growing companies, which leads investors to take huge risks when purchasing these types of stocks.
I use the Chowder Number as a screening metric to discover stocks to be investigated in more detail. I also use it to identify opportune times to add to existing positions in my portfolio. In the second case, I will usually undertake additional due diligence to satisfy myself that the company is worthy of further investment.
Two Recent Applications
In late June, I added to my holdings in two Canadian companies: Power Corporation (POW-T) and Aecon Group Inc. (ARE-T). The financial data presented in this section was taken from the Canadian Dividend All-Star List, available at http://dividendgrowthinvestingandretirement.com. I make a regular contribution to support the website owner, who updates the All-Star List spreadsheet on a monthly basis.
Power Corporation (POW-T)
Power Corp. is an international management and holding company that focuses on the financial services industry. Its subsidiaries include Great-West Lifeco, IGM Financial and Groupe Bruxelles Lambert. As of April 2021, the Demarais Family Residuary Trust controlled about 103 million shares in Power Corp.
Power Corp. is a very conservatively managed company that clearly fits into the category of a high dividend yield, low dividend growth stock. Life insurance companies typically perform quite well in an inflationary environment as they benefit from higher bond yields and future claims that are discounted to a lower present value. The high dividend yield provides stock price support when times are tough.
I pulled some relevant data from the June 30, 2022 edition of the All Star spreadsheet. Power Corp. has a $20.4B market capitalization. Its closing stock price was $33.12 and the trailing 12-month (TTM) price/earnings ratio was 8.0. Referring to Table 1 below, the dividend yield was 6.0%, which is 20% higher than the average dividend yield over the past five years. I estimate future dividend growth rate to be 5.0%, which is slightly lower than the 6.9% dividend growth rate over the past five years. The dividend growth rate may be higher if interest rates continue to rise over the next few years. Overall, I estimate that the long-term return from investing in this stock is 11.0%. This does not include the potential for the price/earnings ratio to adjust upwards to its 5-year average of 10.9. In a worst case scenario, investors can likely count on receiving the 6% dividend with modest dividend growth.
Aecon Group Inc. (ARE-T)
Aecon Group Inc. is an industrial engineering company with global expertise in construction and infrastructure projects, such as light-rail transit. clean energy and nuclear engineering. It is a small cap stock with $790M market capitalization and its closing price on June 30th was $13.13. The TTM price/earnings ratio was 20.3. Referring to Table 1, the dividend yield was 5.6%, which is 75% higher than the average dividend yield over the past five years. I estimate a future dividend growth rate of 7.0%, which is slightly lower than the 8.8% dividend growth rate over the past five years. Overall, I estimate that the long-term return from investing in this stock will be 12.6%.
Being a small capitalization company, Aecon is exposed to higher risks than a larger company. The risk is somewhat mitigated by its substantial order backlog of $6.4B and a $50B active bid pipeline. Aecon earnings are currently depressed and would likely continue to suffer during a recession. However, it is well-positioned to benefit from future clean energy and infrastructure projects over the next decade. I accept the risk of poor performance in the short term, including seeing no dividend increase for a couple of years. In a worst case scenario, there is potential for a dividend cut if we enter into a deep recession.
| Stock | Current Div. Yield (%) | Past 5-Year Ave. Div. Yield (%) | Past 5-Year Div. Growth Rate (%) | Estimated Future Div. Growth Rate (%) | Estimated Long-Term Return (%) |
| POW-T | 6.0 | 5.0 | 6.9 | 5.0 | 11.0 |
| ARE-T | 5.6 | 3.2 | 8.8 | 7.0 | 12.6 |
Using conservative estimates of the future dividend growth rates, the estimated long-term returns from investing in Power Corp. and Aecon Group Inc. exceed my minimum objective of 10%. Moreover, I didn’t include an additional potential return for upwards adjustment in the price/earnings ratio, (P/E)adj over the next few years. The reason I don’t do that is because the current valuation is already factored into the Current Div. Yield. I make a conscious decision to focus on high-quality companies with solid Future Div. Growth, rather than holding a portfolio of undervalued companies that may be of lower quality.
Three Important Points
I would be remiss if I didn’t discuss three important points related to using the Chowder Number. These three factors often impact my final investing decision.
The first point is that this method of estimating the future return of a dividend growth stock involves extrapolating past dividend growth data into the future. As an engineering student many years ago, professors regularly reinforced the dangers of blindly extrapolating data into the future. The intelligent investor needs to project future dividend growth with an abundance of caution. Spend time to understand the cyclicality of the business, as well as the specific company risks identified in the quarterly earnings reports. I can’t overstress the importance of arriving at a conservative estimate of the future dividend growth rate to have a realistic expectation of future investment returns.
The second point is that it is much easier to estimate the future prospects of high-quality companies that operate in stable businesses. This is due to their relatively consistent revenue, earnings and dividend growth, which is typically combined with a long dividend growth streak. Conservative investors seek out companies where the dividend growth can be estimated with a fair degree of certainty because it allows them to narrow down the range of expected returns.
The third point is that an investor can only have a reasonably clear picture of a company’s business after it has survived a significant recession. Recessions reveal weaknesses in a business, which can lead to significant losses in a company that is ill-prepared. Investors benefit the most from owning companies that are able to compound their earnings growth over long periods of time. The compounding effect is reduced with companies that experience regular earnings losses. Thus, it is always worthwhile to carefully study the company’s performance during previous recessions.
Closing Thoughts
In this post, I presented a relatively simple method for estimating the future returns of a dividend growth stock. The method is suitable as a stock screening tool to identify companies for more detailed analysis or to bring attention to companies you hold when they are trading at an attractive valuation. The method was applied to show my reasoning behind adding to two of my existing positions over the summer. Although investing is never easy, it becomes much more manageable when the investor takes a long term view (decades long) and buys high-quality, dividend growth stocks when they offer a reasonable return on investment. It is only through making the effort to understand a company that you will begin to have realistic expectations for its business prospects over the long term.