(Published Dec. 8 by Bob Ciura)
Coca-Cola (KO, Financial) is one of the world's largest companies. Its products are consumed by millions of people every day.
Warren Buffett (Trades, Portfolio), arguably the most successful investor of all time, is a major shareholder in the company. Buffett’s investment conglomerate, Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), owns 400 million shares of the beverage giant.
Coca-Cola pays $1.40 per share in annualized dividends, which means Berkshire will receive $560 million in annual dividends.
Berkshire is a long-term investor. Buffett first purchased shares of Coca-Cola in 1988. That year, Coca-Cola paid 7.5 cents per share in dividends. The stock traded for approximately $2.50 per share after adjusting for stock splits along the way.
Based on Buffett’s original purchase price and the current annual dividend payout, Berkshire will receive 56% of its original investment in dividends this year alone.
This is called yield on cost, and it explains the awesome power of dividend growth investing.
Coca-Cola is a Dividend Aristocrat. This is an exclusive group of companies in the Standard & Poor's 500 that have raised their dividends for at least 25 years in a row.
You can see the entire list of Dividend Aristocrats by clicking here.
Read on to see what would have happened had you reinvested Coca-Cola’s dividends since 1988.
Yield on cost overview
Yield on cost is calculated by dividing a company’s current annual dividend payment by the original purchase price. It is expressed as a percentage.
Yield on cost differs from a dividend yield in that a dividend yield is the current annual dividend divided by the current share price.
This is an important distinction. Yield on cost takes into account the benefits of reinvested dividends over time.
If an investor owns a stock for many years, those reinvested dividends allow the investor to acquire more shares of stock. These shares then generate their own dividends, which can reinvest in even more shares.
This creates a sort of “snowball” effect of compounding interest. This lowers an investor’s cost basis. In some cases cost basis can go to zero, if the investor owns the stock long enough.
With enough time, it is possible to generate annual dividends at or above 100% of the original investment. In this instance, the investor is receiving more in annual dividend income than the entire original investment amount.
It is rumored that Albert Einstein once said compounding interest is the most powerful force in the universe. Whether he said it or not, it’s hard to argue with it.
Coca-Cola is a great example of the power of dividend reinvestment.
The year Buffett purchased Coca-Cola, it was around a 3% dividend yield. That is actually lower than the current dividend yield, which is 3.5%. Relatively speaking, investors buying the stock today are receiving 17% more income for every invested dollar than Berkshire did in 1988.
The reason it is a perfect illustration of the power of yield on cost is its extremely long dividend history.
Coca-Cola as a case study
Coca-Cola has paid a dividend since 1920, a streak of more than 90 years.
In addition, it has increased its dividend for an amazing 54 consecutive years.
Source: CAGNY 2016 presentation, page 45
Dividends have always been a significant part of the company’s capital return program. Coca-Cola paid $25 billion of dividends to shareholders between 2011 and 2015.
This kind of dividend growth produces a very high yield on cost over time. Yield on cost shows the benefits of buying great businesses and holding on for long periods of time.
Coca-Cola is an incredible business. It has a massive global distribution network that provides it with economies of scale. Moreover, it is one of the most valuable brands in the world.
According to Forbes, Coca-Cola holds the world’s fourth-most valuable brand in the world, worth $58.5 billion.
In order to build a high yield on cost, an investor must find great businesses like Coca-Cola that can generate lots of free cash flow. This is critical to maintaining such a long track record of dividends growth.
Coca-Cola generated $8 billion of free cash flow in 2015. That’s more than enough to reward shareholders with dividends, buy back stock and invest in future growth initiatives.
A look ahead
Taking a look at Buffett’s yield on cost on his Coca-Cola investment is certainly a fun exercise. However, what matters to investors now is whether Coca-Cola can continue its dividend growth going forward.
One could argue that Coca-Cola’s best days are behind it. Soda consumption in the U.S. is at a 30-year low. The consumer landscape is changing, and it is important for Coca-Cola to change along with it.
Fortunately, the company is effectively responding to the shift in consumer preferences. It is doing this by investing heavily in categories outside soda. Specifically, the company is building its stills portfolio, which refers to nonsparkling beverages like water, juice and tea.
Source: 3Q Earnings presentation, page 11
Coca-Cola is taking steps to improve its sparkling beverage performance as well. For instance, it is developing more sugar-free options and using smaller pack sizes. This will help increase profits in this segment.
Management expects 2016 to be another year of steady growth. The full-year forecast calls for 3% revenue growth excluding foreign exchange impacts.
Earnings per share, excluding foreign exchange and restructuring costs, should rise at a high-single digit rate.
Source: 3Q Earnings presentation, page 16
The company seems to have a firm plan in place to continue growing revenue and earnings per share over the long term.
Assuming Coca-Cola increases earnings per share by 8% each year, investors can also assume the dividend will grow near the same rate. If dividends are reinvested, total income will grow approximately 11.5% each year.
Iif an investor buys the stock today, yield on cost will rise to 6% in five years. In 10 years, the investor will earn a 10.4% yield on cost. In 20 years, yield on cost rises to 31%.
Final thoughts
Investing for the long term requires patience, but the rewards are plain to see. Earnings 31% of your total investment each year in dividends, is an enticing scenario.
One benefit of holding great businesses like Coca-Cola is that investors can generate enough dividend growth to eventually live off the dividend income.
Yield on cost is how investors can measure the amazing power of compounding interest.
Disclosure: I am not long any of the stocks mentioned in this article.
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