I will offer a summarized answer to the question in the title at the end, but investing is not a simple task, so please bear with me as I use Inter Pipeline (TSX:IPL) as a detailed example for explanation.
Dividend growth doesn’t necessarily lead to price appreciation
Inter Pipeline stock hasn’t really done much in the last year or last five years, for that matter, in terms of its stock price. In the periods, it’s down by about 18% and 20%, respectively. However, since 2002, it has increased its dividend per share by 147%, or 5.8% per year on average.
Five years ago, Inter Pipeline seemed to be a decent income investment as it offered a nice yield of about 5%. Unfortunately, when combined with Inter Pipeline’s price action, the stock’s five-year annualized total returns were only 1%.
Why were the returns so poor when the company has been disciplined in increasing its dividend payout?
From 2013 to 2015, Inter Pipeline increased its cash flow per share by 39% (an 18% growth rate). So, the stock was bid up to high multiples within the period — specifically, cash flow multiples in the range of 17-21. In comparison, Inter Pipeline’s long-term normal cash flow multiple is less than 11.
This indicates that perhaps the normal growth rate of Inter Pipeline supports a multiple of less than 11, and whenever it strays far away from that, it’ll eventually revert to the mean.
A slower growth rate drags down the stock multiple
In late 2017, I wrote that Inter Pipeline will be investing $3.5 billion in a project that was expected to be completed by 2021. However, in the meantime, the company (and its shareholders) won’t get any benefits from the money spent because the plant cannot start generating cash flow until it’s done.
I also wrote that “Since a lot of money will be spent in the next few years, it will probably mean less money for dividend payouts, [and] shareholders should not expect any big dividend hikes in the near future.”
IPL Dividend data by YCharts. TSX:IPL’s 10-year dividend history.
My forecast was right. In 2018, Inter Pipeline increased its dividend by less than 3.4%, below its long-term average rate of 5.8%.
In any case, what all this means is that Inter Pipeline’s near-term growth is going to be slow. As a result, the stock is currently trading at a cash flow multiple of about 7.4. Notably, this indicates that Inter Pipeline is trading at roughly a 34% discount from its long-term multiple.
If the $3.5 billion project, which will be Canada’s first integrated Propane Dehydrogenation and Polypropylene complex, completes with no hiccups, it’ll start contributing to the company’s growth in 2021. Before that, shareholders should expect below-average dividend growth of about 3%.
Is Inter Pipeline a bad investment today?
As Inter Pipeline is expected to experience slower growth through 2021, is it a bad investment today? Not necessarily. At about $21 per share, the stock trades at a discounted multiple. It offers a yield of 8.1%, which was sustained by a recent funds-from-operations payout ratio of about 60%.
The long-term average return of the U.S. stock market is 10%, while the returns of the Canadian stock market tends to be lower. Buyers of Inter Pipeline stock today can get immediate returns from the 8.1% yield and only require a rate of 1.9% long-term growth in the stock to get the 10% returns.
That said, there will be a drag on the stock until the $3.5 billion project comes into service. If this concerns you, choose other stocks with more immediate growth.
Can you get rich from big dividends?
You can get richer by dividends and capital appreciation of your stocks, which contribute to your total returns. Having growth is always preferred over just having a big dividend.
For a company that can sustain its big dividend (and increase the dividend), you will get rich over time. However, the key is to buy when the valuation of a stock is low. And keep in mind that the market is often overly optimistic or overly pessimistic about a stock, which creates periods in which a stock is expensive (e.g., 2013-2015 for Inter Pipeline) and discounted (e.g., perhaps now for Inter Pipeline).
