Dividend Growth Case Study: How McDonald’s Corporation (MCD) Generated a 15.6% CAGR Over 2.1 Years

Rule 2 Analysis:  High Dividend Yield of 3.7%

In April of 2014 McDonald’s had a forward dividend yield of 3.7%. That’s well above average.

One of the ranking factors for The 8 Rules of Dividend Investing is yield. The higher the dividend yield, the better (all other things being equal).

Why does dividend yield matter?

The common-sense answer is that the more your investments pay you, the better. I certainly don’t disagree.

Historically, higher yielding stocks have outperformed lower yielding stocks.

Source:  A Review of Historical Returns by Heartland Funds

McDonald’s actually had the highest dividend yield in the Top 10 stocks the month it was recommended.

Rule 3 Analysis:  Reasonable Payout Ratio & Valuation

High dividend yields are nice, but not if the company can’t sustain them.

That’s where the payout ratio comes into play. All things being equal, The 8 Rules of Dividend Investing prefers a lower payout ratio to go along with a higher dividend yield.

A company cannot sustain a payout ratio greater than 100%. The lower the payout ratio, the greater the ‘buffer’ a company has between its dividend payments and earnings.

Lower payout ratio companies can sustain their dividends even when earnings fall. Companies with dangerously high payout ratios must cut their dividend payments if earnings fall over a prolonged period of time.

That’s a good reason to prefer low payout ratios to high payout ratios.

But there is another reason…

A little algebra tells us that low payout ratio, high dividend stocks are also low price-to-earnings ratio stocks:

High-yield, low payout stocks are value stocks – they have low price-to-earnings ratios. When you combine a business that has a high dividend with a low price-to-earnings ratio, you get what I like to call a “paid to wait” situation…

You get to collect high dividends while you wait for the stock’s valuation multiple to rise.

High yield, low payout ratio stocks have historically performed very well:

Source:  High Yield, Low Payout by Barefoot, Patel, and Yao

In April of 2014, McDonald’s was not a ‘paid to wait’ stock.

It was a high quality business trading at the low end of fair value.

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”
– Warren Buffett

McDonald’s had a price-to-earnings ratio (using adjusted earnings) of 17.7 in April of 2014. The company had a payout ratio of 58%.

This isn’t value territory, but it is certainly not expensive, either.