Dividend Growth Investors, Consider Starbucks

By Markets Fool.com

The dividend growth formula (something I just made up) is pretty simple. There are only two parts: current dividend yield and potential dividend growth. The best stocks score high on both, but those are few and far between. More often, investors have to make compromises, and in those cases I prefer to look at stocks with relatively low current yields but massive potential for dividend growth.

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While the S&P 500 currently offers an average yield around 2.1%, it's often worthwhile to look at stocks yielding well below that average due to their growth potential. Starbucks currently yields just 1.4%, but in five years its dividends could easily double, producing an average annual yield on your original investment above today's current market average. Here's a look at why Starbucks makes sense in a dividend growth portfolio.

Starbucks is still growing rapidly

Starbucks stock currently pays out a modest quarterly dividend of $0.20 per share (1.4% annual yield), which it announced during its fiscal fourth quarter results last year. That's a 25% increase from the fiscal 2015 dividend, and it's a whopping four times higher than Starbucks' initial dividend payment, announced in 2010.

While it's unlikely Starbucks will be able to keep up that dividend growth rate for the next five years, it's not unreasonable to expect dividend growth in the mid-to-high teens, for a couple of reasons.

First, Starbucks continues to grow revenue and earnings at a good clip. In the first six months of fiscal 2016, revenue climbed 10.7%. Operating income increased 13.5% due to leverages in operating expenses, particularly general and administrative expenses. Net income declined year over year due to a one-time gain in the first quarter of 2015, but increased 16.2% in the second quarter.

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Over the next five years, analysts expect Starbucks earnings per share to grow around 19% on an annual basis as the company continues to expand its presence in the Americas and Asia with new stores and products. The company is planning to open 1800 new stores in fiscal 2016, a similar pace to its additions over the past 12 months. That EPS growth supports my second reason for continued dividend expansion.

Room to pay more earnings to shareholders

Starbucks' dividend payout ratio remains relatively low. The company will pay out 42% of its projected earnings as a dividend this year. Compare that with a more established dividend payer in the restaurant space, McDonald's, which consistently pays out dividends in the high-60% range of earnings. That means the dividend growth rate has the potential to outpace Starbucks' already high expected earnings growth rate.

The low payout ratio is partly because the company is also returning capital using a share buyback program. It's currently authorized to buyback 125 million shares (8.5% of shares outstanding), and it repurchased 23 million shares in the second quarter. As Starbucks continues to buyback shares it will gain leverage for its quarterly dividend payouts. For each share management buys, that's one fewer share it has to pay a dividend on.

Additionally, Starbucks has a ton of free cash flow leverage when it eases up on investing in new stores. It's already shifting toward more licensed stores to reduce the capital expenditures involved in developing owned and operated locations, particularly in Europe. Capital expenditures are expected to increase a modest 4% year over year in 2016, compared to the 140% increase it's seen over the past five years. As investment slows, Starbucks will have more uninvested cash that it could return to shareholders.

A quick look at valuation

Starbucks might look a little pricey to some investors considering it trades near 30-times its expected earnings. But consider the significantly slower growing McDonald's is trading around 24.5 time forward earnings, and other global consumer products companies like Colgate-Palmoliveand Kraft-Heinztrade at similar valuations (24-times and 30-times, respectively). On a forward PE basis, the stock's trading 18% lower compared to August of last year. At around $56 per share, it's 12.5% off its 52-week high.

The stock is certainly priced for growth, and with good reason. Its continued sales strength coming from same-store sales growth, an increased number of storefronts, and its consumer-packaged goods segment shows no signs of slowing down. Additionally, its operational leverage is producing even stronger growth in net income.

At a PE around 30, Starbucks seems fairly valued, so investors shouldn't expect multiple expansion. But the dividend, and its enormous growth potential, coupled with its continued strength in earnings growth, means investors won't need multiple expansion to see great benefit from the stock.

The article Dividend Growth Investors, Consider Starbucks originally appeared on Fool.com.

Adam Levy has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.