Monday, May 7, 2012

Investing 101 ... Dividend Update

Intel today raised its quarterly cash dividend by 7%.  Its yield is now comfortably above 3%, and the latest increase is the third by the company in the past two years.

That action caused me to reflect--again-- on the comparative attractiveness of cash dividends on stock in relation to interest paid on government bonds. While the Intel dividend yield is over 3%, interest rates on ten year treasuries are less than 2% currently.

Bonds are no place to be for the long term investor. The shares of dividend paying blue chip companies are the place to be. But let's say exactly why that's the case, since it's a counter-intuitive call and obviously contrary to what most individual investors are doing these days.

Here's the story.

Intel is a strong company that generates lots of cash, which it shares with its owners in the form of dividend increases and share buybacks.

Assuming its earnings increase at an annual rate of 7% the next ten years and that the dividend is increased similarly, the 3% dividend yield on today's share price (cost) will grow to approximately 6% at that time. And its share price will grow by somewhere from 75% to 100% as well.

In comparison, the government bond will pay 2% each year in interest and at the end of the ten years, the initial bond investment will be returned to its owner.

So the stock will pay increased cash flows each year during the ten year period and the bond will pay the same interest as it does today, which is already more than a full percentage rate lower than the cash paid on the shares of stock.

To repeat, the dividend yield on Intel stock at today's price (aka yield on cost) will likely grow from 3% to 6% during the next ten years.

Meanwhile, the interest paid on the government bond will start at 2% and stay there.

The share price of Intel stock should grow by approximately 75% to 100% during the next ten years.

The principal of the government bond will remain the same during the next ten years, but only if the bonds are held to maturity for the full ten years.

As interest rates rise during those ten years, which they will, the principal of the bond will be reduced should the bond need to be sold during the ten year period. The selling bondholder will lose money if he sells prior to maturity.

{Bonds become worth less as interest rates rise. Otherwise nobody would buy an outstanding and previously issued bond during a period of rising rates. They'd only purchase newly issued bonds.}

The shares of Intel stock should appreciate during the next ten years. The shareholder can sell anytime he wants.

Of course, investing in companies like Microsoft, GE, Boeing, Pfizer, Merck, IBM, Exxon, McDonald's, Wells Fargo, JP Morgan, US Bank, Pepsi, Coke, Wal-Mart and many others is similar to investing in Intel.

These companies are also strong cash generators with a solid track record of periodically increasing cash dividends to shareholders based on increased earnings.

But since Intel announced just today its latest dividend increase, I wanted to share my reasoning again as to why the ownership of stocks is preferable to owning bonds, and will be for years to come.

Thanks. Bob.