The Dividend Drill: Evaluating
Long-Term Total Returns
Why dividend yield plus growth equals total return.
by Josh Peters, CFA, Equities
Strategist, Editor, Morningstar
DividendInvestor
If you give a man a fish, he’ll eat for today, but if you
teach a man to fish, he can eat for a lifetime. While
we’re delighted to provide Morningstar’s best incomeoriented stock recommendations to you each month,
we also want to teach what we know and learn about
the art of fishing…for dividends, that is.
What Is Total Return?
Most people think about stocks the same way
Will Rogers did:
After folding dividends into our results, we earned a
total return of 11.3% per year from National City
(7.4% capital gain plus 3.9% in dividends), well above
the 9.1% return from the S&P 500 (7.4% plus 1.6%).
Our $1,656 investment, including reinvested dividends,
grew into $4,843, or $876 more than the S&P 500.
Of this total gain of $3,187, nearly half ($1,465) came
through dividends.
We see that dividends add directly—and often substantially—to the returns earned on long-term stock
investments. But the relationship between dividends
and total return runs much deeper than that. Consider
that doubling of National City’s stock price—what
would prompt investors to pay twice as much for a
share of this bank at the end of 2005 than in 1995?
What Drives Total Return?
Don’t gamble; take all your savings and buy some
good stock and hold it till it goes up, then sell it.
If it don’t go up, don’t buy it.
What Rogers describes—capital gains, the profit realized by the sale of a stock—is only one of several
reasons to own stocks. If you’re trying to make money
in the next 20 minutes, capital gains are the goal.
But if you’re planning to own a stock for 2 years (or
20), the income return of the stock—dividends—
becomes a larger piece of the puzzle.
MDIDDMB0407
Let’s say we bought 100 shares of National City NCC,
a Cleveland-based regional bank, at the end of 1995
for $16.56 per share. In the 10 years that followed,
the share price roughly doubled to $33.57, an annual
capital gain of 7.4%. On the surface, we’ve only
matched the S&P 500, which also rose at a 7.4%
annual pace. Nothing special, right?
What we haven’t done yet is account for dividends.
National City, like many banks, paid a handsome
dividend averaging 3.9% of the share price over this
period. This gave investors the opportunity to realize
regular cash income from their investment without
having to sell shares—or an opportunity to reinvest
the dividends in additional, high-yielding shares.
By contrast, the S&P 500 yielded just 1.6%.
Supplement to Morningstar ® DividendInvestorTM
In the long run, dividend growth will drive the stock
price and, by extension, total returns.
Having successfully expanded its operations from
1995 to 2005, National City’s board of directors raised
the stock’s annual dividend rate from $0.72 per share
to $1.48, for an increase of 106% (7.5% per year).
This steady progress—reflected in the most concrete
way possible, through the dividend—easily justifies
the doubling of the stock price.
In fact, long-term stock returns can be explained
almost fully by this combination of yield and
growth. In Triumph of the Optimists: 101 Years of
Investment Returns, the authors wrote:
The longer the investment horizon, the more important is dividend income. For the seriously longterm investor, the value of a portfolio corresponds
closely to the present value of dividends. The
present value of the (eventual) capital appreciation
dwindles greatly in significance.
In other words, total returns will trend toward
dividend yield plus dividend growth—just as we saw
with National City. The longer we own the stock,
the greater the correlation. Even if we don’t plan on
owning a stock for 101 years (or 10 years, or even
1
1 year), it’s this combination of income and income
A cow for her milk, a hen for her eggs,
And a stock, by heck, for her dividends.
An orchard for fruit, bees for their honey,
And stocks, besides, for their dividends.
growth that forms a foundation for sound
investment value.
To see why this long-term relationship is true, we
need to step back from the day-to-day (or even
year-to-year) changes in the market price and look
at the dividends a stock stands to pay far into
the future.
Williams never won any awards for his poetry. But
his principle—that an investment security is worth
the present value of future cash payments to
its owner—defines to this day the intrinsic value of
an investment.
More on Dividend Theory
Stocks are more than pretty pieces of paper. There
needs to be tangible, underlying value to prompt
an investor to own them. This means hard cash—
most often transmitted via dividends. In his groundbreaking 1938 work, The Theory of Investment Value,
John Burr Williams established that the same rules
for evaluating cash flows applied to every type of
investment. Earnings didn’t count, nor did book value;
these were only proxies for dividend-paying ability.
Only dividends—the cash returned to the investor—
could make a stock worth owning.
To make sure readers got the point, he composed
a poem:
Perpetuities in Practice
Sum of
Remaining
5-Year Bond
Interest Received
Principal Repaid
Year 1
Year 2
Year 3
Year 4
100.00
100.00
100.00
100.00
100.00
1,000.00
—
—
Total Cash Received:
Present Value at 10%
100.00
90.91
100.00
82.64
100.00
75.13
100.00
68.30
1,100.00
683.01
—
—
100.00
82.64
100.00
75.13
100.00
68.30
100.00
62.09
Infinite
620.92
Sum of Present Values
Total Return %
1,000.00
10
Fixed-Rate Perpetuity
Cash Received
Present Value at 10%
100.00
90.91
Sum of Present Values
Total Return %
1,000.00
10
Perpetuity with 5% Annual Growth
Cash Received
Present Value at 10%
Sum of Present Values
Total Return %
2
100.00
90.91
105.00
86.78
110.25
82.83
115.76
79.07
2,000.00
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The Dividend Drill: Evaluating Long-Term Total Returns
Year 5
121.55
75.47
Infinite
1,584.94
To see how this works, it helps to think about a stock
in bondlike terms. With a bond, you have contractually
certain payments of cash; unless the issuer goes
bankrupt (not an issue with Treasuries), you know the
day and amount of each interest payment and the
eventual return of principal.
If we have the current price of the bond, we can solve
for the total return. Consider a bond in the accompanying example. It’s got a 10% interest rate that
matures in 5 years. You know that for each $1,000 of
par (principal) value, you’ll receive $100 in annual
interest. If we demand a 10% return on our investment,
we discount each year’s interest payment by that
rate. Thus the first coupon we clip is worth not $100 in
today’s dollars, but $90.91. The second payment is
worth $82.64, and the third $75.13. By the time we’ve
gotten our principal back in year five, the sum of
these discounted values is $1,000. Assuming we can
purchase this bond at par (100 cents for each dollar of
principal value), our return on investment will be
the 10% annual discount we require. We use a similar
mathematical approach in evaluating the return from
both stocks and bonds, though the securities themselves have critical differences. For one thing, the
timing and amount of dividends is not contractually
certain. A company may fall on hard times, omit
the dividend, and go belly up.
More important, stocks have perpetual lives—there’s
no maturity date with a return of our principal
at the end. Therefore it makes sense to evaluate a
stock’s dividend stream as a perpetuity—a stream
of cash with no end date.
In the second example, you’ll find a $100 annual cash
payment made in each year—just like the bond’s
interest. Each year’s payments are discounted at 10%,
just like the bond. With no maturity date, this discounting continues until the annual payments become
little more than rounding errors (in year 50, for
example, that $100 payment is worth just $0.85 in
today’s dollars). But as each succeeding payment
approaches zero in present-value terms, the sum total
of all payments approaches $1,000. (Our reward for
owning the perpetuity is in those time-value-of-money
discounts.) With a little algebra, we can cut out all
of those payments and simply define total return as
income divided by price—in other words, yield.
account for most, if not nearly all, the annual return
for this stock.
In fact, this is a real stock—General Electric GE,
which at the end of 1955 sold for $57.75. Between 1955
and 2005, GE split its shares 7 times, so each original
1955 share is 96 shares today. And since then, GE has
generated a compound annual total return of 11.6%.
Fully 96% of this return is explained by initial dividend
yield and subsequent dividend growth.
And what of the stock price? Unadjusted for splits, GE
rose from $57.75 to $3,364.80 per share, an annual
growth rate of 8.5%. What could drive growth like that?
The dividend—it rose at a nearly identical 8.3% clip.
Total Return for Fixed Perpetuity 5 Yield
Now, let’s introduce a growth rate to our income
stream. We see that the present value of future
dividend payments doesn’t shrink nearly as fast.
The present value of our first $100 payment a year
from now is still $90.91, but at a 5% growth rate
the second payment will be $86.78 instead of $82.64,
and the third $82.83 rather than $75.13. We’re
starting to collect substantially more cash from this
investment than from the zero-growth stream.
Even this growing stream will eventually generate
payments in present-value terms that approach zero,
but in the meantime the sum of these future payments
is approaching $2,000, not $1,000. Experimenting
with discount rates, we find that we’d have to assess
a 15% time value of money for the net present value
to equal $1,000. But again, the algebra cuts all
of this out—the return is equal to the 10% yield plus
the 5% growth rate.
Total Return for Growing Perpetuity 5 Yield 1 Growth
Perpetuities in Practice
Imagine a stock trading at $57.75 per share with a
$1.60 dividend, for a yield of 2.8%. Over the next
50 years, that dividend grows at 8.3% annually. If the
authors of Triumph of the Optimists are right, this
combination of yield and growth—11.1%—should
Supplement to Morningstar ® DividendInvestorTM
Dividend yield and dividend growth drive long-term
returns, just as the authors of Triumph of the
Optimists claim.
Introducing the Dividend Drill
The DividendInvestor approach starts with this perpetuity view of stocks: What can we expect through
a combination of today’s yield and dividend growth far
into the future?
Stocks don’t have a contractual obligation to pay
dividends, much less increase them. But we can still
estimate the future cash payments of a stock by
establishing the safety of the current dividend and
then evaluating long-term growth potential.
We can and often will start with a stock’s historical
dividend growth rate. But past dividend growth alone
isn’t going to tell us much about how fast the core
business can really grow, or how much that growth
will cost. Growth is not a given, nor is it free.
With current yield as a given, our Dividend Drill is
designed to provide insights into the drivers of
dividend growth. These fall into a pair of distinct
concepts: first, growth of the core business, which
enlarges the pool of dollars available for dividends. Then we add the effect of share buybacks,
which boosts the available dividend dollars for
each remaining share.
3
Separated into these three components, our total
return breaks down as follows:
Return 5 Yield 1 (Core Growth 1 Share Shrink)
To demonstrate how this model works, we’ll run our
formula on US Bancorp USB, a stock I recommended
to DividendInvestor subscribers in November 2005.
Step One: Calculate Dividend Yield
Dividend yield is readily obtainable. We take the indicated dividend rate and divide it by our stock price.
US Bancorp pays $0.40 per share per quarter, or $1.60
per year. The stock recently sold around $35, for a
yield of 4.6%.
Step Two: Estimate Core Growth
Core business growth involves no calculation per se,
but does require some knowledge about the company, its prospects, the industry, the competitive landscape, and even the entire economy. I use several
tools to think about how fast the business can grow.
These include:
3 Historical growth rate
3 Sustainable growth rate
3 Mark to GDP
Looking at long-term growth rates for sales, assets,
and income can point us in the right direction.
For US Bancorp, which has made a lot of acquisitions
in the past decade, these statistics are likely to
be misleading. We want growth only of the core business; we’ll deal with acquisitions separately. But
with a minimally acquisitive bank like TCF Financial
TCB, the long-term records might prove useful. TCF’s
total assets and deposits have risen at respective
6% and 5% annual rates over the past decade,
which—assuming this isn’t contradicted by our other
tools—ought to be a reasonable figure for TCF.
By the way, while we might look at long-term earnings growth, we shouldn’t use earnings per
share, which could double-count the effect of
share buybacks.
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The Dividend Drill: Evaluating Long-Term Total Returns
The sustainable growth rate (SGR) can also point us in
the right direction. SGR represents how fast the
company can grow without raising additional equity
capital, and is calculated as:
SGR 5 Return on Equity 3 (1 2 Payout Ratio)
To understand how this works, think about the business as a savings account. If a savings account pays
10% interest (don’t we wish!) and we never make
withdrawals, our balance will grow by 10% annually.
If we withdraw half of each year’s interest income,
our balance—and with it, our annual income
stream—will grow only half as fast.
Yet just because the SGR suggests theoretical growth
of 10% doesn’t mean the firm will grow that fast in
the real world. US Bancorp is earning returns on
equity in the low 20s while paying out 55%-60% of
profits as dividends, so its SGR is a bit over 10%.
But growing that fast would mean adding $22 billion
in assets every year. Expansion is likely to be
slower than that.
The third tool—my personal favorite—is to set
our growth expectations relative to overall economic
growth. I call this mark to GDP. Real U.S. GDP has
grown at a fairly consistent 3.5% over any long period.
And since corporations report results in nominal
rather than real terms, I add 2.5% for inflation, giving
us a benchmark for business activity of 6%.
Of course, different industries and companies offer a
variety of long-term growth rates. New technologies
and emerging businesses will create more than their
fair share of economic growth, so the average mature
business will probably be closer to 4%-5% than 6%.
And while some businesses may have zero or even
negative growth prospects, it’s tough for almost any
business to grow faster than the economy for very
long periods. We might venture higher rates for wellestablished, wide-moat health-care and technology
firms, but even for great companies like Johnson &
Johnson JNJ or Microsoft MSFT, I wouldn’t bank on
growth of more than 7%-8%.
So how does US Bancorp stack up against this 6%
benchmark? Deposits—the core of the banking
business model—have grown at roughly the same
rate as the economy over time. But because US
Bancorp operates in slower-growing regions—mostly
Midwest and Northwestern states—I knock a point
off this growth rate and use 5%. (It never hurts to
be cautious; we can always be pleasantly surprised
later.) This is well within the bank’s sustainable
growth rate, and, if we back out merger activity, 5%
is reasonably consistent with the past.
Step Three: The Cost of Growth
Core growth adds directly to our total return prospects, but it doesn’t come free. The vast majority of
businesses will have to invest in additional productive
assets for earning power to rise. And earnings
reinvested in the business don’t provide immediate
benefit to shareholders.
Our next step is to calculate how much the core
growth rate will cost per share. We can derive this
from the sustainable growth formula. According
to Wall Street consensus estimates, US Bancorp is
expected to earn $2.78 per share in 2007 and make
a 24% return on equity. The sustainable growth
rate tells us that if 100% of earnings are retained,
the company could grow 24% per year. If we expect
the bank to grow at 5%—less than one fourth
of return on equity—it follows that this growth will
require just 21% of earnings to be reinvested (5%
divided by 24%). Our per share cost of growth is 21%
of earnings per share, or $0.58.
Not every firm will have a return on equity that represents required reinvestment. In some cases, free cash
flow can give us a more accurate picture of reinvestment needs. Free cash flow is exactly what it sounds
like—the net earnings of the business, less any net
investment through capital spending, working capital,
and such. You might think of free cash flow as having
already “paid” for the core growth rate.
Soft-drink giant Coca-Cola KO is a good example of
this. Over the past 10 years, the company has
converted 100% of net income to free cash flow. Its
core growth hasn’t cost anything at all—the per share
cost of growth (assuming we think Coke can maintain
this performance) would be zero. In an extreme case,
like Dividend Portfolio holding Compass Minerals
CMP, free cash flow actually exceeds reported earnings by a fair amount, even though Compass is poised
to expand the core business at about 5% annually.
This step in our analysis highlights the impressive
value of low-cost growth. Even many conservative
investors won’t find midsingle-digit growth all
that inspiring. But when we can obtain that kind of
Dividend Drill Worksheet
Step 1: Dividend Yield
Step 2: Core Growth
Step 3: Cost of Growth
Step 4: Surplus Earnings
Step 5: Share Shrink
Dividend Rate
$
Estimated using:
Core Growth
%
Earnings Per Share
$
Surplus Earnings
$
%
Dividend Rate
$
Stock Price
$
:
Historical Rates
=
Mark to GDP
:
-
Return on Equity
Sustainable
Growth Ratio
X
Earnings Per Share
$
=
Cost of Growth Per Share
$
Dividend Yield
Core Growth
% +
-
Cost of Growth Per Share
$
Stock Price
$
Total Return Estimate
:
=
=
Totals from
Dividend Yield,
Core Growth
and Share Shrink
Surplus Earnings
$
Share Shrink
%
+
Supplement to Morningstar ® DividendInvestorTM
% =
%
5
growth by reinvesting only a small share of company
earnings, we get to have our cake (nice growth)
while getting to eat most of it (through dividends
and buybacks).
Step Four: Surplus Earnings
Out of the company’s pool of earnings, we’ve now
provided for the dividend as well as the cost of
growth. Subtracting these two factors leaves us with
what I call surplus earnings. For US Bancorp,
subtracting the $1.60 dividend and another $0.58 for
reinvestment from anticipated earnings per share
of $2.78 leaves surplus earnings of $0.60 per share.
This surplus generally has just three places to go:
debt reduction (or cash accumulation), share
buybacks, and acquisitions. If US Bancorp isn’t
paying down debt, letting cash pile up, or making
acquisitions, we’re left with buybacks.
Step Five: Share Shrink
Buyback math can boost our total returns significantly.
With the stock at $35, US Bancorp’s surplus earnings
are enough to annually retire 0.017 share for each
share outstanding, boosting our future dividend growth
rate an additional 1.7%. We fold this directly into
our return estimate.
Share shrink emphasizes the advantage of undervalued stocks. All else being equal, a low share price
enables the company to buy back more shares for
each surplus dollar of earnings. And that’s in addition
to the higher dividend yield a lower price delivers.
This is one of the back roads to superior returns
that has made slow-growing but cash-rich businesses
like Altria MO amazing investments over time.
Rather than buying back its own stock, the bank may
opt to buy back some other company’s shares. Growth
by acquisition isn’t tantamount to core business
growth—among other factors, the initial returns are
typically much lower than the firm’s existing return on
equity—but for mature companies, we can assume
they’re paying roughly the same value for the acquisition that they could get from buying back their
6
The Dividend Drill: Evaluating Long-Term Total Returns
own shares. (In the interest of simplicity, I’ll assume
that most small, bolt-on acquisitions won’t destroy
shareholder value.)
Bottom Line
Adding US Bancorp’s yield (4.6%), core growth rate
(5%), and share shrink (1.7%) generates a prospective
total return of 11.3%. That’s a nifty return by
most standards, which is why we added the stock to
our Dividend Portfolio once we found it trading
at a margin of safety we deemed reasonable. And if
anything this dividend growth forecast—6.7%—looks
conservative compared to past growth in the
double digits. I actually expect dividend growth of 8%
or better in the next five years.
Using the Dividend Drill
For the steady, conservative stocks we seek in
DividendInvestor, I’m finding the Drill works quite
well. It’s simple and comprehensive, and helps
us understand what we own and what to expect.
Like any model, it has its drawbacks. It lacks the
comprehensive application of the discounted
cash-flow methodology Morningstar uses to derive
fair value estimates. It’s not well suited to a firm
whose profitability or growth is in flux. And we
need some assurance that the dividend will rise as
fast as our core growth and share shrink terms
project. Some cash-rich businesses—like Wall Street
Journal publisher Dow Jones DJ—fail to invest
their surpluses wisely. If historical dividend increases
are significantly smaller than projected growth,
watch out.
Most important, the Drill is for long-term investors
only. In the short term, whatever returns the
Drill suggests will get swamped by short-term price
swings. But the longer our time horizon, the greater
the likelihood that our returns will match this
model. Look for us to refer to the Drill frequently in
the issues ahead. œ
The Math Behind the Drill
Combining the sustainable growth rate with the Gordon
growth model.
by Josh Peters, CFA, Equities
Strategist, Editor, Morningstar
DividendInvestor
The underlying methodology of the Dividend Drill is
based on a well-known equity valuation model, the
one-stage Gordon growth model:
68% in 2006 and a 43% payout ratio indicated
for 2007, could conceivably expand at a rate of almost
40% annually. Were that true, we’d all be eating
a lot more chocolate soon.
If a firm’s SGR is in excess of the growth potential
of existing operations, it follows that the firm need
not retain as much profit as its current payout
ratio implies. These retained profits are instead being
channeled into other purposes: reduction of net
debt, share buybacks, or acquisitions.
Stock Price 5 Dividend / (Required Return2Dividend Growth Rate)
and the sustainable growth rate, or SGR:
Earnings Per Share Growth 5 Return on Equity 3 (1 2 Payout Ratio)
For the Drill model, we use the stock’s current price,
Consider Buying price, or fair value estimate as the
stock price term and solve for required return, which
becomes the prospective total return. The Gordon
growth model is thus rearranged as:
Total Return 5 (Dividend / Stock Price) 1 Dividend Growth Rate
We then assume that dividend growth will match that
of earnings over the long term, and substitute the SGR
for the dividend growth term:
Total Return 5 (Dividend / Stock Price) 4 [Return on Equity 3
Our model is predicated on a stable return on equity
and, by extension, a stable capital structure—incremental capital commitments to be funded by existing
proportions of debt and equity. That leaves us
with two potential uses for excess earnings: buybacks
and acquisitions. We further simplify the opportunity
set by assuming that acquisitions—including the
benefit of any merger synergies and future growth of
the acquired operation—aren’t made at valuations
too far from the company’s own share price.
That leaves share buybacks as the model’s use for
retained earnings not needed to support the expansion of core operations. The impact of share buybacks
is to shrink the number of shares outstanding while
earnings, all else being equal, hold constant. These
buybacks are thus directly accretive to dividend
growth per share.
(1 2 Payout Ratio)]
Further Development
This stage of the model’s development is incomplete.
Many, if not most, mature firms with high returns on
equity have indicated SGRs far in excess of likely
industry growth, usually capped at or near long-term
nominal growth of U.S. GDP (about 6% annually). To
the extent that certain industries, like health care, are
gaining share as a proportion of economic activity, we
may assume a growth rate slightly in excess of likely
nominal GDP growth, as we do with J&J.
In the final iteration of the model’s development, we
replace the SGR with our estimate of actual earnings
growth of core operations (core growth) and instead
evaluate the impact of earnings that remain after
funding the current dividend and core growth. One
more step remains: How much does core growth cost?
This is obtained by dividing this core growth forecast
by return on equity, which yields the required retention ratio (the complement of payout ratio) and multiplying this term by earnings per share:
Cost of Growth Per Share 5 (Core Growth / ROE) 3 EPS
Yet the problem of excessive SGRs remains. For
example, Hershey HSY, with a return on equity of
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7
Having established how much it costs to fund growth,
and using the current dividend rate as a given, we can
evaluate the earnings left after these two uses of
cash. Dividing by the share price yields our final Dividend Drill term, which we call share shrink:
evaluated over a 5- to 15-year horizon. Any intermediate-term deterioration in growth or return on
equity would prompt us to reduce our core growth
and return on equity estimates accordingly.
Variations
Share Shrink 5 (EPS 2 Dividend2 Cost of Growth Per Share)/Share Price
Now we have the complete Dividend Drill model:
Return 5 (Dividend / Share Price) 1 Core Growth 1
[ (EPS 2 Dividend 2 Cost of Growth Per Share) / Share Price ]
Big Picture
Theoretically, the Dividend Drill could be applied to
any stock that pays a dividend. By assuming a
hypothetical dividend paid out of retained earnings
not needed for reinvestment, it could even be
used to appraise the total return potential of nondividend-paying stocks.
However, with only one stage, and that assuming a
core growth rate and a return on equity in perpetuity,
the model presents two theoretical challenges:
First, growth may not continue at that rate indefinitely; second, incremental returns on equity should
eventually be competed down to a normal rate of
profit. Thus the Drill lacks the rigor of a complete
discounted cash-flow analysis that ends in a terminal
return on equity equal to the cost of equity capital.
Further, because the share shrink term is contingent
on the stock price at the time buybacks are made
(rather than our price at the time of analysis), the
eventual contribution to dividend growth from share
buybacks will vary.
We solve (or, perhaps more properly, evade) this challenge by e using the Drill only for relatively mature
firms with stable (or improving) competitive characteristics and sustainable capital structures and r maintaining vigilance over the stocks evaluated with
the Drill. Morningstar analysts keep watch over firms’
competitive positions and realistic long-term growth
expectations. In practice, this tends to be
8
The Math Behind the Drill
The message behind the Dividend Drill is to incorporate the three underlying drivers of returns: current
income, income growth, and the cost of that growth.
Yet not every firm’s financials or form of organization
support a plain-vanilla, EPS-based use of the
Drill. Compass Minerals, for example, needs to spend
only 50%-60% of its annual depreciation. As a result,
earnings understate free cash flow by a significant
margin. In cases such as this, we may use a simplified
version of the drill:
Return 5 (Free Cash Flow / Stock Price) 1 Free Cash Flow Growth Rate
Free cash flow is defined as cash from operations less
capital expenditures. Since investments to support
growth—capital spending plus net additions to
working capital—are already accounted for, we’ve
already “paid for” the company’s long-term growth
rate. Further, free cash flow is assumed to be used for
a combination of dividends and buybacks; because
both of these terms are divided by the stock price to
generate our dividend yield and share shrink terms,
we can simply take free cash-flow yield to represent
both terms.
In some cases—such as master limited partnerships,
which pay out nearly all of operating cash flow to
unitholders—the current dividend and cost of growth
per share combined exceed the earnings of the
enterprise. In these cases, the share shrink term may
well be negative—the firm faces continual equity
issuance to fund growth. While this may appear dilutive to earnings, as long as the firm’s return on equity
exceeds its cost of equity capital, such issuance will
be accretive to dividend growth. œ