Monday, November 5, 2007

Dividend Income vs. MMA

What is the primary reason you invest in dividend stocks? For me, it is a means to build a growing income that can be relied on during retirement. So, why choose dividend stocks instead of another income investment? I view it as an opportunity to see my earnings grow each year, not only from reinvested dividends, but from an increasing dividend rate.

Why would you assume the equity risk and invest in a dividend stock if you could earn a better return in a less risky money market account (MMA)? When I screen for worthy dividend investments, one of my first tests is to determine if the investment will perform better than a MMA over time.

Last week I posted a Stock Analysis on PAYX including a link to a PDF containing a detailed analysis. In this article, I will explore the section titled Dividend Income vs. MMA (located in the top right section of the above linked PDF). This section helps me determine if the investment's dividend income could possibly pay more than interest earned from a MMA, over time. Below is a description of each item in the Dividend Income vs. MMA section from page 2 of the analysis:
MMA Rate:
Representative high money market rate (MMA) at a financial institution that is insured by the FDIC up to the legal limit ($100,000). Currently using a 20 year Treasury as a proxy.

NPV MMA Diff.:
The basis of this calculation is a hypothetical $1,000 investment in this stock and a MMA earning the MMA Rate above. The value calculated is the net present value (NPV) of the cumulative differences between the dividend earnings of this investment and the interest income from the MMA over 20 years. Other assumptions include: 1.) dividends grow at the Dividend Growth Rate above, 2.) dividends are reinvested, 3.) share price appreciation is not considered, 4.) interest income is reinvested in the MMA. A Star is added for amounts over a certain amount depending on how long a company has paid a dividend. $10,000 for a company that has paid a dividend for less than 10 years, $7,500 for a company that has paid a dividend from 10-25 years and $2,500 for a company that has paid a dividend for more than 25 years. A Star is deducted if the amount is negative.

Years to >MMA:
The number of years until dividend earnings exceed the earnings from a hypothetical money market account earning the MMA rate above, considering the other assumptions listed in "NPV MMA Diff." above. A Star is added if the number of years is less than 5.
Considering the proxy was paying 5.36% APR at the time this article was written, yield's on most dividend paying stocks are well below that of a high-yield MMA . Thus, my emphasis on over time. As noted in the NPV MMA Diff. description above, my chosen time horizon is 20 years. Given the future uncertaintly, if it takes less than 5 years for the investment's annual earnings to exceed the MMA's annual earning (Years to >MMA), a Star is added.

To quickly perform this test, I enter 10 years of dividend payments and the current yield of a stock into my model. Given those inputs, the model will calculate the NPV of the earnings difference on a hypothetical $1,000 investment in the stock and a MMA. If the amount calculated is negative, you would earn more by putting your money in a MMA. Even if the amount is positive, a lot can happen in 20 years, so I look for a $10,000 cushion. This is the level I have elected to add a Star.

Let me point out some potential flaws to my calculation:
  1. I assume a steady interest rate for the MMA over the 20 year period.
  2. Since I am looking at the ability of the investment to generate income, I ignore any share price appreciation.
Due to the great disparity between certain high-yield MMA rates and published rates ( today is reporting the national average for MMA is 3.5%), I have chosen to use a rate that I am actually getting. Over time, I will probably normalize the MMA interest rate I use by building an average of the available high-yield MMA rates .

Before I perform the tests above, I check to see if the company has lowered its dividend over the last 10 years.

What is the first thing you look at when evaluating a dividend stock?

Full Disclosure: No position in the aforementioned securities. See a list of all my income holdings here.

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Tags: PAYX