IBM: “Big Blue” Brings Big Dividend Potential



On September 1, I published a blog listing First Share’s inaugural “Dividend-a-Month Club” stock picks for September. The goal of this so called “Club” is to help readers build a portfolio of dividend-paying stocks that will generate dividend payments each month of the year. The list provided on September 1 included the five best stocks offered as part of the First Share program that also pay a dividend during the month of September. Inclusion into this club is dependent upon three factors: 1) Dividend yield, 2) Dividend growth history and 3) Dividend payout ratio. IBM scored the highest of the September dividend payers.

Current Dividend Yield

Interestingly, at 1.82%, IBM has the lowest current dividend yield of the five stocks that were included on the list. The average dividend yield of the other four stocks is currently 3.6%. However, this presents me with the perfect opportunity to show exactly what I want to accomplish with this monthly list. While the current dividend yield is an important factor to consider, it is not the only factor. Equally, if not more, important is the company’s history of growing its dividend, as well as its ability to maintain that growth, going forward.

Dividend Growth History

To be included in the First Share “Dividend-a-Month Club”, a company must have raised its dividend each year of the previous five years and IBM fills that requirement. IBM has raised its dividend for 11 consecutive years and during that period has increased its dividend by an average of 17% per year (compounded).

Dividend Sustainability

To me, the most important factor to consider is the sustainability of a company’s dividend. Any company can essentially mortgage its future to pay its shareholders a fat dividend for one year, but only the most financially-stable companies can continue to pay an attractive dividend over the long-term.

To gauge a company’s dividend sustainability, I look at its payout ratio, or its dividend per share divided by its free-cash-flow per share. This ratio tells you what percentage of a company’s annual free cash flow it is paying out as a dividend to its shareholders. Generally, the lower the better because it provides the company with more of a financial cushion should it go through a down period.

For 2011, IBM is on track to pay out approximately 21.4% of its free cash flow as a dividend, so its payout ratio is just that, 21.4%. That is slightly below its five year average payout ratio of 22%. In my opinion, this is a very solid number and gives the company plenty of room to increase its dividend, going forward. In fact, I believe that IBM may raise its quarterly dividend to $0.85 per share ($3.40 annual dividend) in June 2012. For those interested, I arrive at this estimate by simply assuming the company maintains its payout ratio of 22% and multiply that by the average analyst estimate for 2012 free-cash-flow per share ($15.68). Theoretically, the company could also increase its payout ratio and, therefore, pay an even larger dividend, but it has been fairly consistent in paying out 22% – 23% of its annual free cash flow in dividends.

Yield-to-Cost Explained: Assume for a moment that I am correct and that IBM increased its quarterly dividend to $0.85 per share ($3.40 per share per year). If I were to buy shares in IBM at its current price of $165.10 and received $3.40 per share in dividends, my yield-to-cost would be 2.1%. Yield-to-cost is determined by simply dividing a company’s dividend by the investor’s average cost basis in a stock. This is also another opportunity to stress the importance of dividend growth. If IBM were to continue to increase its dividend by 16% per year, then by 2016 it would be paying an annual dividend of $6.09 per share. If you paid $165.10 per IBM share, you would essentially be receiving a dividend yield (on your investment) of 3.7% in 2016.

Conclusion

IBM has a solid history of maintaining, and growing, its dividend. Given its low payout ratio, it appears as though the company will be able to sustain that growth, going forward. While its current dividend yield is the lowest of our September picks (1.82%), investor’s who purchase the stock at current prices could see their yield-to-cost rise significantly over the course of the next several years.

IBM shares are offered as part of the First Share program for DRIP investors. To get started now, click here!

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