Recently Goldman Sachs Group, Inc. (NYSE:GS) issued a note that contained an extremely bullish prediction for the S&P 500 over the next couple of years:
We are raising our S&P 500 dividend estimates and index return forecasts for 2013 through 2015. We expect S&P 500 index will rise by 5% from the current level to 1,750 by year-end 2013, advance by 9% to 1,900 in 2014, and climb by 10% to 2100 in 2015.
This prediction is based on two assumptions: first, that the S&P 500 P/E ratio will expand over the next two years, and second, that dividends will rise by roughly 30% in the same time.
I don’t take predictions like this seriously. They are often wrong or subject to revision, and investing based solely on other peoples’ opinions almost never turns out well. But Goldman Sachs Group, Inc. (NYSE:GS) also listed 10 of its favorite dividend stocks, some of which have a place in my Ultimate Dividend Growth Portfolio, which you can track here. Let’s take a look at three of Goldman Sachs Group, Inc. (NYSE:GS)’s picks and see if they really are good dividend growth stocks.
Moving money, both around the world and back to investors
The Western Union Company (NYSE:WU) is part of The Ultimate Dividend Growth Portfolio, and Goldman seems to agree that the stock has exceptional dividend growth prospects. The current dividend yield is 3%, but the stock has run up about 14% since the end of April, pushing down the yield. The Western Union Company (NYSE:WU)’s dividend is fairly new, starting only in 2006, but it has grown considerably since then. The last dividend increase, which occurred at the end of last year, was an impressive 25%.
Barrons recently ran an article that was bullish on The Western Union Company (NYSE:WU), and I tend to agree. One point made was the impressive cash flow, which has totaled about $1 billion for the past few years and is expected to be about $900 million in 2013. Of course, it is from this cash flow which dividends are paid, and based on the current payment and the current share count the company will pay out about $285 million in 2013. This is around a 30% payout ratio, which is extremely low and suggests that The Western Union Company (NYSE:WU) has plenty of room to grow the dividend.
The rest of the free cash flow is being used to buy back shares, and this has the effect of lowering the payout ratio since the total dividend payment decreases along with the share count. This will allow the company to grow the dividend faster than earnings growth while keeping the payout ratio in check.
How fast does the dividend need to grow for the stock to be fairly valued? I’ll do a simple dividend discount calculation to find out.
Over the next 10 years The Western Union Company (NYSE:WU) needs to grow the dividend at an annual rate of about 9% for the stock to be reasonably priced today. With the average analyst estimate for annual earnings growth sitting at 10.83% and a payout ratio of just 30%, the dividend growth could very well be much faster than 9%. Even after a big run up in the stock price, Western Union is still a bargain dividend growth stock.
Addicted to dividends
The Ultimate Dividend Growth Portfolio does have a cigarette stock, but not the one that Goldman likes best. While Lorillard Inc. (NYSE:LO) is part of the portfolio, Goldman Sachs Group, Inc. (NYSE:GS) prefers Philip Morris International Inc. (NYSE:PM).
The big difference between the two companies is that Philip Morris, after its spin-off from Altria, sells only in international markets. The U.S. market faces far stiffer regulation and has seen a multi-decade decline in volumes, whereas many emerging markets offer ample opportunity for growth.
Philip Morris International Inc. (NYSE:PM) pays a nice 3.6% dividend yield, significantly lower than Lorillard Inc. (NYSE:LO)’s 5% yield. But Philip Morris International Inc. (NYSE:PM) likely has better growth prospects, which means dividend growth should be faster. As a percentage of 2012 free cash flow Philip Morris International Inc. (NYSE:PM)’s payout ratio is about 67%, quite a high value. But analysts are projecting 11.23% annual earnings growth over the next 5 years, and if the dividend grows at that rate the stock is significantly undervalued today.
At 11% annual dividend growth over the next decade Philip Morris International Inc. (NYSE:PM) stock would be worth about $131 per share today, a 38% premium to the current price. The minimum dividend growth rate required for the stock to be fairly valued is just 6.8%, and the company should be able to handle that easily.
Because Lorillard has a much higher yield its dividend growth doesn’t need to be as fast. Both stocks are fantastic dividend growth stocks, but since having two cigarette stocks in The Ultimate Dividend Growth Portfolio seems like overkill, I’ll stick with Lorillard for now. But either one would be a good position to have.
The problem with telecoms
Goldman Sachs Group, Inc. (NYSE:GS) also recommends AT&T Inc. (NYSE:T), a standard dividend stock for many years. But I don’t like AT&T, at least not at the current market price.
Historically telecom stocks like AT&T Inc. (NYSE:T) have high yields and relatively slow dividend growth. But when the stock prices get too high, pushing the yields down, the stocks look awfully unattractive. AT&T Inc. (NYSE:T) was yielding as high as 6% in late 2011, but now the yield sits at about 4.8%.
A 4.8% yield looks good, but you need to consider the dividend growth. Over the last decade the dividend has grown at an annualized rate of 4.8%. That’s not bad given the yield, but that growth has slowed dramatically in the past few years. The 5-year annualized dividend growth rate is just 2.4%.
At the current yield AT&T needs to grow its dividend by around 3% annually for the stock to be fairly valued. It’s not that AT&T is overly expensive, it’s that it’s average at best. The dividend likely won’t grow much faster than 3%, and compared to the above two stocks that could see dividend growth well beyond their required rates, AT&T just isn’t all that exciting. It’s consistent, sure, but without a higher yield there are much better dividend growth stocks out there.
There is no telecom in The Ultimate Dividend Growth Portfolio for exactly this reason, and until yields go up that fact is unlikely to change.
The bottom line
The Goldman Sachs Group, Inc. (NYSE:GS) list of dividend stocks is a little hit-or-miss. Of the three stocks I looked at The Western Union Company (NYSE:WU) and Philip Morris International Inc. (NYSE:PM) are great choices but AT&T is mediocre at best. Just because a stock has a high dividend yield doesn’t necessarily make it a good dividend stock.
The article Goldman’s Dividend Picks originally appeared on Fool.com and is written by Timothy Green.
Timothy Green owns shares of Western Union. The Motley Fool recommends Western Union. The Motley Fool owns shares of Philip Morris International. Timothy is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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