Since Christmas Eve, the price of Procter & Gamble stock has declined 8.5% from $93.89 to $85.90 to give the consumer giant a 3.00% yield for those contemplating buying the stock right now. That is something that catches my attention because, in the past 25 years, Procter & Gamble never had a year in which its dividend had an average yield of 3% or higher until 2010 (however, during the 2010-2015 stretch investors could have purchased Procter & Gamble with a 3% yield or better in each of those years).
Does Procter & Gamble yielding 3% indicate that the stock is worth buying, given its favorable dividend valuation compared to the past generation? Not quite. An important thing to understand about recent trends regarding Procter & Gamble’s stock is that the dividend payments are eating up more payments than ever before (I have a loose definition of “ever before” to only encapsulate data from 1980 to now). From 1980 to 2008, Procter & Gamble’s dividend neatly fell into the 25-40% range with only an occasional aberration outside that range, such as 2006 and 2007 when the payout ratio was at 43% and 41%.
Since I know there are some new readers on the site, I’ll try to give a concise background on what this means: a company’s payout ratio tells you how much of a company’s profits get paid as a dividend, and how much the management team gets to keep to try and grow the business. If a business makes $10,000 in profit and pays out $2,500 in dividends, the payout ratio is 25%. The lower the payout ratio, the more money the management team gets to keep on hand to grow the business. When the payout ratio gets high, people start to worry about the dividend safety going forward (what if you don’t have enough profits to cover it?) or in other cases worry that the future growth rate of the company will slow down because you have a lower amount of cash coming to make new investments.
In the case of Procter & Gamble, the company is still dealing with the effects of raising the dividend from $1.45 to $1.80 over the course of the financial crisis from 2008 through 2010 as profits declined from $3.64 to $3.53. It has led to a situation today in which Procter & Gamble pays out a $2.57 dividend while making $4.22 in profits for a dividend payout ratio of 61%.
That’s a twenty-two point percentage increase from a decade ago, when Procter & Gamble was only paying out 39% of its profits to shareholders as dividends. It’s a slightly difficult situation to get yourself out of, because Procter & Gamble has been raising its dividends for 58 consecutive years, and that tradition will almost certainly continue this April. To get the company back on track, though, you need to rack up a couple years in a row in which the company grows profits faster than the company raises its dividend payment.
What has hurt the company is that unit sales—which is just a technical way of saying the total amount of Tide detergent, Gillette razors, and so on that the company sells to consumers—have only been growing at 3.5% globally after spending the past three decades growing at over 6% annually. Usually, you can wring out 10-12% profit growth from 6% sales gains because the price of the goods increases faster than inflation and the costs of producing these goods is scalable in a way that it becomes cheaper to produce in bulk with simultaneous technology advances, but you can only get profit growth in the 6-8% range when your sales are growing at 3.5% annually.
When you include the fact that Procter & Gamble needs to lower its dividend payout ratio, and profits are going to grow in the 6-8% range, you can see that it is unlikely that Procter & Gamble will consistently maintain the 10.5% annual dividend growth rate that it has achieved over the past ten years.
I continue to think that Procter & Gamble is an excellent company, deserving of one of those twenty punch-card placements you get in your investing life, to borrow a famous phrase from Warren Buffett’s parlance. Racking up growing dividends while owning an immensely profitable company that will be so for years to come is a great way to go through life.
But the question is different when you are making a buy decision: You are likely looking for a value and a growth component. In short, my negative sentiment regarding Procter & Gamble could be described as this: The 3% yield mark doesn’t mean as much as it might have in the company’s past, because it is now paying out 61% of profits as dividends rather than something below the 40% range. The stock is trading at 20x profits, which would be exciting if I thought profits would grow north of 8% over the next 5+ years. If the stock came down another 10%, I think the valuation would reach a point where mid-single digit growth over the coming few years would be tolerable based on the deal you’re getting. The company is excellent in terms of quality, and that is why it merits a hold, but because you’re looking at mid-single digit growth, I’d still want more of a discount treating it as a top priority. I’d much rather take 3% yield from Exxon or a 3.8% yield from Chevron based on the prices and growth prospects existing right now, but that’s just me.