A Prescription for Massive Dividend Growth

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

A growing dividend is a wonderful thing. As each year passes by the income generated by that dividend gets bigger and bigger, and if those dividends are reinvested the magic of compounding reaches a whole new level. When I see a company which has increased its dividend at an average rate of over 20% per year for the last decade, you better believe I take notice. Some hunt only for yield, but yield is only half the story. The other half of the story is growth, and the Walgreen Company (NYSE: WAG) is a prime example of the benefits of a growing dividend.

Company Profile 

Walgreen is the largest retail pharmacy in the United States, operating close to 8,000 drugstores. Total revenue in 2011 reached $72.2 billion. Walgreen has been paying a dividend since 1933, and has raised the dividend in each of the past 36 years. The company derives about 65% of total sales from prescription sales and is responsible for 20% of all retail prescriptions in the United States. 

Walgreen competes directly with CVS Caremark (NYSE: CVS), another behemoth in the retail pharmacy market. Another competitor is Wal-mart (NYSE: WMT), although both Walgreen and CVS are more specialized. Of these three companies, Walgreen clearly offers the superior dividend.

<table> <tbody> <tr> <td><strong>Company</strong></td> <td><strong>Dividend Yield</strong></td> <td><strong>10-Year Avg Dividend Growth Rate</strong></td> </tr> <tr> <td><strong>WAG</strong></td> <td> 3.09%</td> <td> 21.3%</td> </tr> <tr> <td><strong>CVS</strong></td> <td> 1.35%</td> <td> 19.2%</td> </tr> <tr> <td><strong>WMT</strong></td> <td> 2.14%</td> <td> 18.6%</td> </tr> </tbody> </table>

*Yield based on most recent quarterly dividend

Although all three companies have grown their dividend at a substantial rate over the past decade, Walgreen's dividend has grown the fastest. The real difference, though, is that Walgreen now offers a yield over 3%, while Wal-mart and CVS offer significantly lower yields. All three companies have the growth part of the story down, but only Walgreen supplies a sufficient yield.

The Stock

<img src="http://media.ycharts.com/charts/6c85213762b3429b707378a8aa6417e8.png" />

WAG data by YCharts

Walgreen's stock currently trades around $35 per share, quite close to the stock price 10 years ago. The stock reached a high of nearly $45 in 2011 only to fall below $30 in 2012. 

Dividend Profile

Let's take a look at the astounding growth of Walgreen's dividend. Here is the history of annual dividend payments for the last 10 years.

<table> <tbody> <tr> <td><strong>Year</strong></td> <td><strong>Dividend</strong></td> <td><strong>Growth</strong></td> </tr> <tr> <td><strong>2003</strong></td> <td>$0.1613</td> <td>10.25%</td> </tr> <tr> <td><strong>2004</strong></td> <td>$0.1913</td> <td>18.60%</td> </tr> <tr> <td><strong>2005</strong></td> <td>$0.235</td> <td>22.84%</td> </tr> <tr> <td><strong>2006</strong></td> <td>$0.285</td> <td>21.28%</td> </tr> <tr> <td><strong>2007</strong></td> <td>$0.345</td> <td>21.05%</td> </tr> <tr> <td><strong>2008</strong></td> <td>$0.415</td> <td>20.29%</td> </tr> <tr> <td><strong>2009</strong></td> <td>$0.50</td> <td>20.48%</td> </tr> <tr> <td><strong>2010</strong></td> <td>$0.625</td> <td>25.00%</td> </tr> <tr> <td><strong>2011</strong></td> <td>$0.80</td> <td>28.00%</td> </tr> <tr> <td><strong>2012</strong></td> <td>$1.00*</td> <td>25.00%</td> </tr> </tbody> </table>

*Only three payments have occurred so far. This value is what the total will be assuming the Q4 dividend is the same as the Q3 dividend.

As stated above, the dividend has grown at a breakneck pace over the past decade, increasing by a factor of 6 during that time.

To determine the stability of the dividend I'll calculate the historical payout ratio, which I'll define as the annual dividends paid divided by the free cash flow.

<table> <tbody> <tr> <td>Year</td> <td>FCF</td> <td>Payout Ratio</td> </tr> <tr> <td>2003</td> <td>$696</td> <td>23.92%</td> </tr> <tr> <td>2004</td> <td>$713</td> <td>27.69%</td> </tr> <tr> <td>2005</td> <td>$134</td> <td>180.28%</td> </tr> <tr> <td>2006</td> <td>$1,102</td> <td>26.35%</td> </tr> <tr> <td>2007</td> <td>$571</td> <td>60.78%</td> </tr> <tr> <td>2008</td> <td>$814</td> <td>50.78%</td> </tr> <tr> <td>2009</td> <td>$2,184</td> <td>22.69%</td> </tr> <tr> <td>2010</td> <td>$2,730</td> <td>22.62%</td> </tr> <tr> <td>2011</td> <td>$2,430</td> <td>30.45%</td> </tr> </tbody> </table>

For the past three years the payout ratio has been extremely low, ranging from 22% to 30%. This means that the dividend has two sources of growth going forward: earnings growth and payout ratio growth.

Valuation 

Instead of trying to predict the future growth rate of Walgreen's dividend, let's turn the question around. Instead of asking "How much is a share of Walgreen worth?" let's ask instead "How fast does the dividend need to grow to justify the current share price?" I'll use the dividend discount model to answer this question. This method of valuation assumes that the value of a company is purely the value of all future dividend payments discounted back to today. This is reasonable for a dividend-focused investor. I'll use a discount rate of 8%, since this is roughly the long-term average return of the market as a whole. 

I'll employ a simple two-stage growth model. For the next 10 years the dividend will grow at x% per year, and after that the dividend will grow at 3% in perpetuity. Our goal is to find x such that this calculation yields the current share price. If the answer is lower than a reasonable expectation of future dividend growth, then Walgreen is a good value. Otherwise, the stock may be too expensive.

Using the above parameters the value of x which gives the current share price of $35.62 is 9.92%.

The Bottom Line

In order to justify the current share price the dividend must grow at a rate of at least 9.92% over the next 10 years. Given that the average growth rate over the past 10 years is over 20% and the payout ratio is a paltry 30%, it seems very likely that Walgreen's dividend will surpass this growth rate. This means that Walgreen is currently undervalued on a dividend basis and offers a dividend investor both sufficient yield and extremely high dividend growth potential. If your portfolio is mainly focused on dividend income, then Walgreen should fit in perfectly.


TheBargainBin has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus