Using trailing 12 month ROE and book value multiples allows us to see what kind of long-term return one could reasonably expect from each investment. Chubb managed a 10% return on equity, which when divided against its price-to-book ratio of 1.4, reveals an effective return to shareholders of 7% per year, assuming zero growth in underwriting. (Chubb’s 10-year average revenue growth is a respectable 4% per year.)
A BDC’s dividend yield is a good measure of expected returns. As both BDCs in this article yield just under 10% per year, investors should expect returns of 10% per year as all earned income is paid out as a distribution to investors. In a taxed portfolio, BDCs after-tax returns are virtually the same as the after-tax returns from a top insurance company, since taxes are passed through the RIC format of a BDC and taxed at income tax rates for individuals.
This leads me to ask a very important question: is the promise of a high dividend payout ratio truly worth taking more risk? The returns from a BDC and The Chubb Corporation (NYSE:CB) adjusted for taxes are substantially similar, but the risk profile (junk debt vs. A-rated government debt) couldn’t be more different.
Investors who can afford to forgo current income would be better off to look through property and casualty insurance companies trading at very low multiples of 10-12 times earnings. While dividends won’t match the high dividends from BDCs, investors accept far less risk in their portfolio. If you don’t absolutely need a high yielding asset, then a lower payout insurance company looks much better on a risk-adjusted basis.
Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Jordan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
The article High Dividend Yields Come at a Price originally appeared on Fool.com and is written by Jordan Wathen.
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