Investing for Retirement Dividend Income Doesn’t Come Without Risk

William is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When approaching retirement one moves from thinking about asset accumulation to thinking about income generation. The Fed’s low interest rate policies leave investors seeking risk free income out in the cold. The national average APY for five year jumbo CDs resides at 0.91% according to bankrate.com. In this case, the risk/reward relationship comes into play: Higher yields will come from assuming more risk. While it’s never advisable to put all your eggs in one basket, placing a portion of your retirement nest egg into good solid dividend paying stocks may be worthy of consideration.

Investing in dividend stocks involves more than looking for high yields. The driving forces or fundamentals behind the generation of the dividend need consideration:

1.) Market leadership - Companies in market leadership positions command greater pricing power and brand recognition. People tend to buy products with names they trust and from companies they think will stay around.

2.) Wide moat - The security and stability as well as potential growth of a dividend will flow from a company possessing a wide moat or high barriers to entry such as a distribution network, infrastructure such as with railroads, and highly recognizable brands.

3.) Cash generating capability Dividends come from a company’s cash stash. Growth in the dividend comes from increasing free cash flow or cash flow left over from the purchase of important items like equipment and trademark maintenance.

4.) Low payout ratios Investors need to look for companies that pay a relatively low amount of free cash flow and cash on the balance sheet. My personal preference lies at less than 50% of dividend to free cash flow and cash on hand; however most large, mature companies pay out more due to more limited opportunities for expansion relative to smaller growth oriented companies.

4 Companies with dividends to consider

Beverage giant Coca-Cola (NYSE: KO) currently yields around 2.7% as of this writing. Coca-Cola leads the global beverage industry with a $167 billion market cap and revenues of $12 billion in the last quarter.  Coca-Cola grew revenue in its sparkling and healthier, non-sparkling categories 3% and 10% respectively in its most recent quarter; pretty good in an increasingly health conscious marketplace.

Coca-Cola’s massive distribution network, trademark and brand recognition serve as barriers to entry for new companies wanting to enter the marketplace providing protection for the dividend.

Coca-Cola’s excellent cash situation adds to its appeal as a solid dividend play. Free cash flow grew 32% over the last five years according to YCharts.  Its cash, short term investments, and marketable securities stand at a healthy 54% of stockholder’s equity in its most recent quarter. Coca-Cola also sports low payout ratios relative to free cash flow and cash on hand at 39% and 13% respectively as of the most recent quarter.

Coca-Cola’s shareholders will benefit from its expansion into emerging economies and its broadening diversification in the non-sparkling category.

The world’s largest restaurant chain McDonald’s ) yields a very appealing 3.4%. McDonald’s carries a market cap of $91 billion and $7.1 billion in revenue for its most recent quarter. McDonald’s revenue and free cash flow declined 0.2% and 16% respectively in the last quarter due to adverse foreign currency translations and a softening global economy.

Its barrier to entry stems from the impossible to duplicate golden arches trademark. Also, the distribution system supporting its 30,000 stores allows McDonald's to sell high quality food at a reasonably low price.

McDonald’s grew its free cash flow 12% over the past five years. The payout ratios of dividend to free cash flow and cash on hand of 67% and 106% respectively reside in the high range for my personal tastes. Limited expansion opportunities due to its large size compel McDonald’s to pay more of its cash to the shareholders.

McDonald’s will continue to dominate as it continues to grow overseas and retain customers domestically.

Western railroad company, Union Pacific ) dominates the west along with its only major competitor Burlington Northern Santa FE. Union Pacific yields 2.1% as of this writing. Its market cap stands at $61 billion with revenue of $15.6 billion in the last quarter. Union Pacific grew its revenue 5% driven mainly from robust growth in automotive and chemicals transportation in its most recent quarter.

Again, Union Pacific’s vast railroad infrastructure and lack of multiple competitors ensures future growth in free cash flow and corresponding dividend growth.

Over the past five years, Union Pacific grew its free cash flow an astounding 166% according YCharts. Its dividend to free cash flow and cash on hand and investments stood at 56% and 36% respectively in its most recent quarter.

Union Pacific will continue to grow its revenue as it flexes its pricing capability and benefits from the need for efficient transportation.

Mega giant retailer Wal-Mart ) commands a formidable presence at your local shopping center. Its dividend yield sits at 2.3%. Wal-Mart sports the highest market cap on the list at $129 billion. In the last quarter Wal-Mart’s revenue clocked in at $114 billion.

Its vast distribution system allows Wal-Mart to sell products cheaper than competitors while at the same time growing profitability.

Wal-Mart grew its free cash flow an amazing 124% over the past five years according to YCharts. Like McDonalds, Wal-Mart’s relatively small room for expansion compels it to pay more of its cash to shareholders. The ratio of dividend to free cash flow and cash on the balance sheet stands at 64% and 54% respectively.

Wal-Mart plans on expanding into markets occupied by the likes of Dollar General and Family Dollar by opening smaller versions of itself complete with groceries and pharmacies. It will be interesting to see how that will play out.

Conclusion

On the whole, investing in these companies provides a higher yield than your standard savings account; however, it comes with a relatively higher risk. The inherent structural advantages noted above will ensure safety and future growth of income from those businesses. Given the rock bottom risk-free savings rates prevalent over the past five years even income oriented investors need to assume some risk.


stockdissector owns shares of Coca-Cola,McDonald's and Union Pacific mentioned above. The Motley Fool recommends McDonald's Corp and The Coca-Cola Company. The Motley Fool owns shares of McDonald's Corp. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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