Where Do Diageo plc’s Dividends Come From?

It can be quite perplexing, looking at the way different FTSE 100 companies pay dividends and how much value investors put on them.

DiageoTake Diageo (LSE: DGE) (NYSE: DEO.US), for example. It’s a solid dividend-paying company, and over the past five years has been handing out around half of its annual earnings as cash to shareholders — and that level of cover should keep investors happy in the short term while maintaining the safety of the dividend over the long term.

Steady rises

It’s unlikely that Diageo’s earnings will falter in any significant way. In fact, we’ve seen steady earnings per share (EPS) growth for the past five years, with increases in double digits for the past three. There’s a 5% EPS fall predicted for the year ending June 2014, but that should be reversed in 2015 — and the dividend is still expected to be lifted by 7%.

Diageo’s reliability comes from the strength of its brands and its worldwide presence — Johnnie Walker, Smirnoff, and a host of other booze labels all belong to Diageo, and sales have kept going right through the recession.

Low yield?

Things get interesting when we look at Diageo’s dividend yield figures. Despite a good proportion of earnings being paid as cash, the dividend only yielded 2.5% last year — falling short of the FTSE’s average of 3%. And for the current year there’s only a slightly higher 2.7% predicted, with 2.9% on the cards for 2015.

Meanwhile, other FTSE companies are paying 5% and better. People are clearly prepared to pay a lot more for Diageo shares in relation to the dividend than they are for other shares. But why?

There’s a clue in Diageo’s annual dividend increases. At results time last year the final dividend was raised by 9%, and the interim payment this year was lifted by the same percentage.

Over the past few years, we’ve seen rises in Diageo’s total dividend of 5.5%, 6%, 7.7% and 9% — all easily covered by rises in earnings. Forecasts suggest a further 7.4% this year and 8.5% next.

Appreciation is what matters

In the long run, it’s not the annual dividend yield that matters to an investor, as that depends on the share price each year — it’s the cumulative effective yield based on the price we actually paid for the shares that counts.

If you buy a share that yields just 2.5% this year, but that grows at 7% per year (slightly less than Diageo’s recent average), in five years you’ll be getting a yield of 3.5% on the price you actually paid, and in 10 years it’ll be up to 4.9%.

And on top of that, you’ll almost certainly get some decent share price appreciation into the bargain.

I really can see why people value Diageo’s dividends so highly.

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Alan does not own any shares in Diageo.