Often, what we use is the average dividend growth rate (DGR) over a period of time. This metric allows us to make some educated guesses about the future DGR. For instance, in my analyses, I use the average DGR over the last ten years, that is between 2003 and 2012, as a basis for estimating future DGRs.

But what actually is the average DGR of a stock. For instance, what is the average DGR of Wells Fargo (WFC) or of Coca-Cola (KO).

To say the truth, the average DGR of a stock will depend on how you actually calculate it. Different methods will yield different results.

So how do you calculate the average DGR of a stock?

There are at least three methods to calculate the average DGR of a stock over a period of time. These are:

1. The straight-line growth rate method.
2. The year-over-year average growth rate method.
3. The compounding growth rate method.

Notably, these methods also apply to calculate any average rate of growth over a period of time.

This week, I present each method and the mathematics behind them. Next week, I will apply these methods to two stocks, WFC and KO, and discuss their advantages and shortcomings.

The Straight Line Method

The straight line method is probably the easiest way to calculate the (or should I say an) average DGR of a stock.

All you need is the annual dividend at the beginning of the period (ADbeg), the annual dividend at the end of the period (ADend), and the number of years in the period (N).

Then, to find the average DGR, you put the numbers into the following equation:

This method yields the overall DGR over the period divided by the number of years in the period.

The Year-over-year Average Method

With this method, you need to calculate the annual DGR for each pair of consecutive years in the period. To do so, you need the annual dividend for a given year (ADy) and the annual dividend of the prior year (ADy-1). The annual DGR is calculated using the following equation:

Once you have calculated the annual DGR for each pair of consecutive years, you simply add them up and divide the sum by the number of years in the period (N).

This method will give you the average of the annual DGR over the period.

The Compound Rate Method

This method is a bit more complicated but the inputs are the same as the Straight Line Method, that is the annual dividend at the beginning of the period (ADbeg), the annual dividend at the end of the period (ADend), and the number of years in the period (N).

To calculate the average DGR, you put the numbers in the following equation:

The result of this method will be the constant annual DGR that has allowed the annual dividend to compound from the annual dividend at the beginning of the period (ADbeg) to the annual dividend at the end of the period (ADend). In other words, this method gives you the constant compounding rate over the period.

Conclusion

Though these methods use similar and sometimes identical inputs, they are more than likely to yield different results.

Which method is the best, which method is the worst? We will see next week when we apply these methods to WFC and KO.

General Dynamics is an aerospace and weapon systems supplier.

With a market cap around $27G, General Dynamics is a midsize player in the industry.

General Dynamics is divided into four main business units: aerospace, combat systems, marine systems, and information sytems and technology.

Notably, though most of the business units are mainly defense-oriented, the aerospace unit is mostly civilian. In that sense, General Dynamics is the company behind the Gulfstream airplanes.

General Dynamics is headquartered in Falls Church, in the state of Virginia, USA.

Shares of General Dynamics are traded on the New York Stock Exchange (NYSE) under the ticker “GD”.

GD is part of the S&P500 index.

GD is classified in the industrials sector according to the Global Industry Classification Standard (GICS).

Dividend Calendar

GD pays dividends four times per year.

GD generally declares its dividends in December, March, June and August and generally pays its dividends in February, May, August and November.

GD typically increases its dividend once a year, in March. The last increase, in March 2013, was of 9.8%.

GD has increased its dividend for 22 consecutive years, making it a dividend contender, i.e. 10 to 24 years of consecutive increases.

Financials

• Earning growth (10 year average): -189.62%
• Free cash flow growth (10 year average): 5.96%
• Dividend growth (10 year average): 16.60%
• Return on equity (10 year average): 17.63%

The evolution of the earnings, dividends and earning payout ratio over the last 10 years is presented below.

As can be seen, over the past ten years, the earnings have been growing relatively smoothly, that is until 2012. I assume that 2012 was more an anomaly than the norm.

If we ignore 2012, the payout ratio has been hovering between 20% and 27%, which is relatively low. However, having a low payout ratio does help when things get though as in 2012.

Also, the payout ratio appears relatively stable, indicating that the dividend has not be growing much faster than the earnings, which is good.

The evolution of the free cash flow, dividends and free cash flow payout ratio over the last 10 years is presented below.

Contrary to the earnings, the free cash flow has always been positive over the last ten years. However, the average growth rate has been modest at around 6%. This is much less than the average dividend growth rate which stands at 16.6%.

The difference between the two growth rates translates in a rising payout ratio. In that sense, the payout ratio has been slowly but steadily increasing. From a low 17% in 2003 to near 40% in 2012.

Though a payout ratio of 40% is safe, I prefer a stable payout ratio since it shows that the growth in dividends is not fuled by expansion of the payout ratio.

It remains that 2012 seemed to have been a bad year for GD. Maybe GD will resume its typically growth patten in 2013.

Valuation

To calculate a fair value for GD, I calculate how much one share will return in cumulative dividends over the next 20 years, adjusted for inflation.

For GD, I’ve used the following inputs:

• Share price: $78.50
• Dividend rate: $2.24
• Dividend growth rate:
  • Optimistic scenario: 16.0%
  • Realistic scenario: 12.8%
  • Pessimistic scenario: 9.6%
• Inflation rate: 3.5%

The optimistic DGR generally corresponds to the 10-year average, while the realistic and pessimistic DGRs respectively correspond to 80% and 60% of the optimistic DGR.

According to the inputs, the estimated fair values of GD range from $81.46 (pessimistic) to $162.85 (optimistic) with a realistic value of $114.41.

With a current share price at about $78.50, GD appears slightly undervalued.

In that sense, I’ve calculated that the DGR would need to be 9.24% over the next 20 to justify the current price of $78.50.

Estimated Cash Return

To calculate the ECR of GD, I’ve taken the following inputs:

1. Initial investment: $1000
2. Current yield: 2.85%
3. Estimated dividend growth rates:
   • Optimistic scenario: 16.0%
   • Realistic scenario: 12.8%
   • Pessimistic scenario: 9.6%

Notably, the estimated DGRs are the same as the DGRs used for valuation.

With a current yield around 2.85% and with the dividend growth rates used above, the ECR of GD will equal the initial investment between 13 to 17 years, which is reasonable.

However, given the recent earning and free cash flow growth rates, the 17 year scenario is more probable. In such a scenario, a $1000 investment in GD would return more than $4000 over 30 years, which is not bad.

Currency and Withholding Tax Considerations

As a US corporation, GD pays its dividends in US dollars.

For Canadian residents, the basic withholding tax rate of 15% will apply unless the shares are held in a registered account.

For US residents, there is no withholding tax on dividends paid by GD.

For foreign residents, the basic withholding tax rate of 15% will likely apply (assuming that a tax treaty exists).

Conclusion

Being a supplier of military and civilian products, GD is probably less sensitive to defense budget cuts that always seem to loom.

However, GD appears to have maintained a relatively safe payout ratio, making the dividend safe for the moment.

Still, I would prefer to see steady earning growth over the next few years to see if 2012 was only a bad year or a sign of things to come.

For the time being, I will keep GD on my watchlist.

What do you think of GD?

Full Disclosure

I currently own shares of GD.

Disclaimer

I am not a financial advisor. All the information presented here are not financial advices. They represent my own opinion regarding a particular stock. Please do your own research before buying and selling stocks.

Among them, some have stood out more than others. Below are eights books that have shaped and changed my investing philosophy. I think that these books should be part of any dividend investor bookshelf (or e-reader).

Please note that I’ve personally purchased all these books.

General Investing Books

The Intelligent Investor by Benjamin Graham

This is one of the first investing book I’ve read. It should be a must-read for anyone wishing to buy and sell stocks on the stock market. It is the reference.

The chapter on Mr. Market is worth the price of the book.

To read and re-read!

The Theory of Investment Value by John Burr Williams

I’ve purchased this book after reading The Warren Buffett Way by Robert Hagstrom.

This book is full of maths but it clearly explains that the value of a stock is the value of its future dividend payments. I use the teachings of this book to value my dividend stocks.

Dividend Investing Books

The Ultimate Dividend Playbook by Josh Peters

I’ve bought this book with The Single Best Investment, below. This was the first book I read that was focused on dividend investing. It probably changed the course of my investing journey.

The book makes a great case about the benefits of dividend investing.

It also present a process to evaluate dividend stock. A great book.

The Single Best Investment by Lowell Miller

I’ve read this book shortly after The Ultimate Dividend Playbook, above. Though I preferred the The Ultimate Dividend Playbook

The Strategic Dividend Investor by Daniel Peris

What I like from this book is that the author, a historian before being a fund manager, explains with clarity that dividend investing is not a new fad, it is what stock investing should be.

General Books

Great By Choice by Jim Collins and Morten T. Hansen

This book thought me a principle that I since follow: Set a pace and follow it, through thick and thin. This is a trait of great companies and I try to apply it to my dividend investing philosophy. Pick this one up. It is worth it.

Understanding Michael Porter by Joan Magretta

This book is all you always wanted to know about Michael Porter’s competition theory without having to read the real stuff (I’ve tried but it’s tough!).

More seriously, what I’ve learned from this book is that competing to be the best is a losing proposition.

The Strategy Paradox by Michael E. Raynor

The key concept of this book is that having a strategy that depends only one possible future is a recipe for disaster if the futrue unfolds differently.

This book also made me realize that companies that appear to be involved in seemingly unrelated businesses (e.g. Microsoft) may do it on purpose because they understand that they cannot predict the future. They make several bets.

So, these were my eight must-read books.

What books have changed your investing philosophy?

Overview

Lockheed Martin is a military contractor mainly involved in the development of aerospace and other weapon systems.

With a market cap around $33G, Lockheed Martin is a midsize player in the aerospace and defense business.

Though based in the USA, Lockheed Martin has operations and partnerships in several other countries (e.g. Australia, Canada and the United Kingdom). Lockheed Martin is the company behind the development of the F-35 next-generation fighter aircraft.

Lockheed Martin is headquartered in Bethesda, in the state of Maryland, USA.

Shares of Lockheed Martin are traded on the New York Stock Exchange (NYSE) under the ticker “LMT”.

LMT is part of the S&P500 index.

LMT is classified in the industrials sector according to the Global Industry Classification Standard (GICS).

Dividend Calendar

LMT pays dividends four times per year.

It generally declares its dividends in January, April, June and September, and pays its dividends in March, June, September and December.

LMT typically increases its dividend once a year, in September. The last increase, in September 2012, was of 15%.

LMT has been increasing its dividend for 10 consecutive years, making it a dividend contender, i.e. 10 to 24 years of consecutive increases.

Financials

• Earning growth (10 year average): 15.20%
• Free cash flow growth (10 year average): -3.07%
• Dividend growth (10 year average): 24.44%
• Return on equity (10 year average): 98.58%

The evolution of the earnings, dividends and earning payout ratio over the last 10 years is presented below.

Over the last 10 years, the dividend has grown much faster than the earnings (24.44% vs. 15.20%). This is clearly apparent from the rising payout ratio which has grown from a relatively low 20% to a still reasonable 50%.

Though the payout ratio is still reasonable at 50%, it remains that there is a clear uptrend that should be watched. In the long-term, the dividend growth will likely have to converge toward the earnings growth. Otherwise, the dividend will become unsustainable.

The evolution of the free cash flow, dividends and free cash flow payout ratio over the last 10 years is presented below.

Though the free cash flow average growth rate over the last 10 years is -3.07%, this is mostly due to the free cash flow of 2012 which was significantly lower than usual.

However, overall, the free cash flow shows an upward trend.

In that sense, the payout ratio was relatively stable under 50% over most of the last decade, except for 2012.

If we assume that 2012 was more of an outlier than a sign of things to come, LMT dividend appears safe. However, the dividend growth will likely need to slow down to allow the earnings and free cash flow to catch up.

Valuation

To calculate a fair value for LMT, I calculate how much one share will return in cumulative dividends over the next 20 years, adjusted for inflation.

For LMT, I’ve used the following inputs:

• Share price: $102.00
• Dividend rate: $4.60
• Dividend growth rate:
  • Optimistic scenario: 24.0%
  • Realistic scenario: 19.2%
  • Pessimistic scenario: 14.4%
• Inflation rate: 3.5%

The optimistic DGR generally corresponds to the 10-year average, while the realistic and pessimistic DGRs respectively correspond to 80% and 60% of the optimistic DGR.

According to the inputs, the estimated fair values of LMT range from $279.90 (pessimistic) to $838.90 (optimistic) with a realistic value of $480.79.

With a current share price at about $102.00, LMT appears significantly undervalued.

In that sense, I’ve calculated that the DGR would need to be only 4.61% over the next 20 to justify the current price of $102.00.

Notably, a DGR of 4.61% is about a third of the recent growth in earnings.

Estimated Cash Return

To calculate the ECR of LMT, I’ve taken the following inputs:

1. Initial investment: $1000
2. Current yield: 4.51%
3. Estimated dividend growth rates:
   • Optimistic scenario: 24.0%
   • Realistic scenario: 19.2%
   • Pessimistic scenario: 14.4%

Notably, the estimated DGRs are the same as the DGRs used for valuation.

With a current yield around 4.51% and with the dividend growth rates used above, the ECR of LMT will equal the initial investment between 9 to 11 years, which is pretty fast.

In that sense, the faster a stock returns its purchase price in dividends, the better. That reduces the risk as you depend less upon future dividend growth to justify the current price. Understandably, the farther you look in the future, the more unpredictable the DGR will be.

Currency and Withholding Tax Considerations

As a US corporation, LMT pays its dividends in US dollars.

For Canadian residents, the basic withholding tax rate of 15% will apply unless the shares are held in a registered account.

For US residents, there is no withholding tax on dividends paid by LMT.

For foreign residents, the basic withholding tax rate of 15% will likely apply (assuming that a tax treaty exists).

Conclusion

Being in the defense business, LMT is always likely to suffer budget cuts from the governments which buy its products.

However, countries will always maintain armies which always need to buy new and improved weapon systems. So long as humans remain human, I think that LMT has a bright future.

Also, at the current price, it seems that LMT is significantly undervalued. I will definitely further investigate this stock. LMT looks like a diamond in the rough. Maybe this is where value is hidden in the current richly valued market.

What do you think?

Full Disclosure

I don’t currently own shares of LMT.

Disclaimer

I am not a financial advisor. All the information presented here are not financial advices. They represent my own opinion regarding a particular stock. Please do your own research before buying and selling stocks.

About a month ago, I’ve initiated a small position in AFLAC (AFL) (see my post here).

Back then, I’ve estimated the value of AFL to be between $57.73$ and $127.58$. I’ve also mentioned that should the price of AFL remain under $57, I would add to my stake.

Well this week, true to my words, since the price of AFL was below $57, I’ve added to my stake. With this purchase, AFL now represents about 2% of my dividend portfolio.

What do you think of this purchase? Do you own AFL?