The One Number That Drives Long-Term Returns

Dividend Growth: The Quiet Engine of Wealth 

Dividend growth investing sounds simple, but doing it well for decades is not. Markets get noisy. Numbers get confusing. That’s why we wrote Dividend Growth: The Quiet Engine of Wealth—a practical guide to building a framework you can stick with when things get uncomfortable. You can get a free copy here. 

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If you could only look at one number to judge whether a dividend can keep growing for decades, what would it be?

In this episode, we strip investing back to first principles. Greg talks about why investors get overwhelmed with data and how focusing on the wrong metrics can quietly lead you off track. Using a simple hot dog stand analogy, he explains why familiar numbers like return on equity (ROE) and return on assets (ROA) can distort reality, especially when leverage enters the picture.

From there, he introduces return on invested capital (ROIC) and shows why it does a better job connecting business quality to long-term dividend growth. Later, Greg addresses what ROIC can’t tell you and why context always matters. 

Along the way, he walks through real-world examples, including Kraft Heinz ($KHC), Southern Company ($SO), Williams-Sonoma ($WSM), and Microsoft ($MSFT), to show how capital allocation decisions compound over time. 

[00:11] Introduction

[02:50] Information overload and the danger of focusing on the wrong numbers

[04:40] The hot dog stand: ROA vs. ROE and the role of leverage

[08:15] Why both ROA and ROE can mislead dividend investors

[09:35] Return on invested capital (ROIC) explained in plain English

[13:30] ROIC, cost of capital, and long-term value creation

[14:55] Case study: Kraft Heinz and why high yield can be a trap

[18:30] Case study: Southern Company and when low returns still “work”

[22:10] Case study: Williams-Sonoma and disciplined capital allocation

[24:55] Case study: Microsoft and the power of long-term compounding

[29:10] The limits of ROIC and why incremental returns matter

[31:25] Final takeaway: one number, long time horizons, evolving businesses

Disclaimer: Past performance does not guarantee future results. This episode is for educational purposes only and is not investment advice.

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Transcript

[00:00:11] Greg Denewiler:

This is Greg Denewiler, and you are listening to another episode of the Dividend Mailbox, a monthly podcast about dividend growth. Our goal is to stuff your mailbox full of dividend checks. When they grow over time, a funny thing happens: you create wealth.

Welcome to Episode 55 of the Dividend Mailbox. Today we're gonna take a slightly different approach. We're gonna look at if we could only pick one number to evaluate a company as to whether it's a good long-term investment, what would that number be? I'm gonna equate this to flying an airplane. You got a lot of different gauges giving you little incremental details, but there's really just a couple of ’em that are extremely important, and no two flights are ever exactly the same. So we're gonna dive into how these different numbers can tell completely different stories on the same company. And there's one number that we think does help point to sustainable dividend growth, but you have to look at the context of what's going on inside the business. It's never that simple.

Just as a quick note before we get into this: dividend growth investing sounds simple, but doing it well over long periods of time takes discipline and patience. These episodes give you pieces of how we think about it, but if you're trying to build wealth, it helps to have a clear framework you can come back to when things get uncomfortable, which is why we wrote Dividend Growth: The Quiet Engine of Wealth. Ultimately, the real goal of it is to help you tune out the noise and make better long-term investment decisions. So if that interests you and you'd like a free copy, you can find it in the show notes or at growmydollar.com/dividend-growth-book. With that, let's get into the episode.

So before we get into our number, it's just been a casual observation, and personally I've seen it. Investors tend to struggle not for lack of information. There's plenty of information out there. In fact, there may be too much. But on the other side, they struggle with what to do with the information, or they focus on the wrong numbers. They really latch onto company numbers or analyst numbers that are reported. They feel like it's precise, it's accurate, and the problem is all of this stuff has a little gray area in it. Everything is open to some interpretation and different degrees of manipulation, as you can feel like you're doing everything right. It sure looks like this should be a big winner, but then you end up disappointed. You can own a company that looks great on one valuation basis, but there may be other pieces of the puzzle that don't add up.

So we're gonna try to come up with an approach that will help give you an idea of how these things can be interconnected. We're not looking for the shortcut. We're not looking for the magic formula. We're stepping back and just saying, okay, what does it actually take to drive sustainable growth over time, and what are some things that will potentially mislead us?

So to start building this episode, a great way to explain the concept that we're gonna get into here is just to take a look at a hot dog stand. We're gonna keep it really high level. We are ignoring all the accounting issues that come with a normal business, and we're just trying to show you the difference between three different ways of valuing the effectiveness of management and whether they're getting the return on their business that they should.

So if you can go out and buy a hot dog stand for $1,000, and that includes the hot dogs, and your hot dog stand earns $100 in a year, that means if you're using the simple return on assets measure, you've got $100 divided by $1,000, which is your total assets. That equals a 10% return. Now, if you're gonna use the return on equity way to measure the profitability of this company, if you pay all cash for it, it's the same return. You have no interest costs or anything. So the $100 divided by $1,000, that's the same 10% when you're looking at all cash. The return on assets and return on equity number is the same.

But here's where things start to get more complicated. You go to your friendly banker and you say, “I wanna run a hot dog stand. I have $100 here, but I need $1,000. Would you please loan me $900? If you will do an interest rate of 5%, then I think I can make this work.” And the banker says, “Great, that's our going rate. So here's $900. At the end of the year, you owe me $45 of interest.” In the back of your mind, you're thinking this hot dog stand earns $100 and I have to pay $45 in interest. Then that's gonna leave me with 55 bucks. And if you divide $55 by the equity that you have in it, which is only $100, you have a little better than a 50% return on your investment.

Well, that sounds pretty good, but it's the same hot dog stand. If you just step back and think about this for a minute, it's the same level of profitability, but it all comes down to how it was financed. And in this case, when you've got a leveraged investment, what happens on return on assets? You take net income divided by your total asset base. After your $45 of interest, you have net income of $55. $55 divided by $1,000 is 5.5%.

So what do you have here? You have the leveraged hot dog stand. Using the return on equity number, it earns a return of a little over 50%. Using the return on assets formula, it earns 5.5%. It's all about how your hot dog stand was financed. So which number do you use? That becomes one of the questions. These measures can potentially lead you to the wrong conclusion if you don't understand what's behind them.

Return on equity is greatly influenced by leverage, and the problem with leverage is if the core business is not that profitable, when you get the first hiccup in the economy or with the company, you just don't have a whole lot of margin of safety. It just kills your potential dividend growth. Return on assets can punish a company that's asset heavy. It can actually make a business that's very asset light look better. Each of ’em have a flaw. Each of ’em potentially can be manipulated by management, and neither one of these is really telling us whether this business can sustainably grow its dividend.

So now we're gonna look at one more formula. The great thing about return on invested capital is that it helps level the playing field. It's not perfect, but it gets you farther down the road of, all right, take out how management is manipulating their asset base. It does a better job of neutralizing it.

So now I want to try to make this as clear as possible, because return on invested capital sounds complicated. But this is just about understanding the concept, not getting into the weeds on the numbers. And I will tell you, here's another case where you can look this up and you're gonna potentially get different ways to calculate it.

So in planning, at least the way we think about return on invested capital is this: how much operating profit does a company generate from every dollar of capital that's actually invested in it? And that's both debt and equity. The formula that we use is after-tax operating income divided by invested capital. And I'll explain invested capital here in a minute.

But for this example of our hot dog stand, we're gonna keep taxes out of it just to try to keep it as simple as possible. So let's look at these two pieces. Operating income is the profit the business generates before any debt, interest, taxes, special charges come after that. So we divide that by invested capital. And our definition is total assets of the business minus current liabilities, and then we add back short-term debt.

The simple explanation there is accounts payable. Vendors that sell inventory or the components of inventory to a company usually give ’em net 30. So as long as they pay in 30 days, there's no interest. The company is not financing that asset. So invested capital is meant to represent basically either equity or debt that was raised to fund the business.

So the hot dog stand has $1,000 of total assets. We're going to assume there's $100 of inventory. If we buy those hot dogs on a credit card and we pay it off at the end of the month, there's no interest on that credit card. That $100 is what we're going to call vendor-financed. We subtract that from the total assets because we didn't have to put that $100 into the business.

So for our simple example, that means that invested capital in the business is $900. The hot dog stand generates $100 of operating income, and we're going to say that is after tax. So the return on invested capital is 100 divided by 900, which is about 11%. The takeaway: that number is telling you how productive the business itself is, not how financial engineering can be used to move the numbers around. And they can actually move a lot.

Now, again, you may be wondering why in the world am I going through all this? It's pretty simple. The goal is to find companies that create value long term, and in that value creation, they raise their dividend every year. And in the end, whether the company pays dividends or not, this drives the bus on shareholder returns.

In this case, an 11% return on that hot dog stand is pretty competitive. The long-term return of the stock market is 10%, so it's slightly above that. If you had a choice to invest the money at 10% in the market or go out and buy a hot dog stand at 11%, the hot dog stand is going to create value long term because it's earning more than what that money cost us doing something else.

Now, one step farther: the total cost of capital for a company is its equity and their debt cost. You blend those together depending on how much you borrow, and if a company is earning more than its cost of capital, that's how companies create value long term. Return on invested capital is a number that's going to give you a good indication of that.

So to put it very simply, if you have ROIC, return on invested capital, if it's 15% long term and their cost of capital is 10% and the dividend yield is 3%, you have an extra 2% spread in there over time. That's how you're gonna create a growing dividend. It's oversimplified, but that's a good way to think about it.

Now, hopefully this all comes together. I'm gonna give you four examples of real life and how it applies in the real world of investing. Then we're gonna go kind of from worst case to best case.

So let's just start with Kraft, and I picked Kraft for a specific reason. You may or may not know it is a large position of Berkshire Hathaway. There's no silver bullet in this game, but return on invested capital really explains why Kraft has been a horrible investment for Berkshire Hathaway.

So in July of 2015 is when Berkshire Hathaway entered Kraft Heinz. Why he's been in it for 10 years, I don't know. He doesn't ask my opinion. It basically came about through a merger with Kraft and Heinz. Berkshire Hathaway helped finance it. At that point, the stock was around $80. It paid a $2.20 dividend. It was not quite 3%.

Well, 10-plus years later, the stock is now $24. The dividend's been cut to $1.60, and based on the $24, it currently yields 6.6%. The total return, if you would've reinvested the dividend over that period of time, has been a negative 58%. Same money in the S&P 500 would've earned basically 300%.

So Kraft Heinz has not been a winner by a long shot. Return on invested capital in June of ’15 was around 3%. In December of ’17, it had actually moved up to 12%, but it didn't stay there very long. Probably the average over the 10-year period has been less than 5%. So that right there tells you they are not earning their cost of capital.

And if you look at return on assets over that period, the average has been basically less than 5%. Return on equity has been roughly 6%. So what Kraft shows: one of the things that happened in the merger, the balance sheet has a lot of goodwill on it. So you've got a much bigger asset base based on how the two companies were put together, but they don't have the profitability on that larger asset base. They have great brands. They generate cash flow, but they're stuck really trying to go anywhere with it.

When you got a low return on invested capital number, it gets hard to maneuver and to create value on a longer-term basis. It's not hard to figure out why this thing has not been a productive asset. And one takeaway I hope you take is you gotta be careful looking at just yield. Unless something really changes, there's no reason to believe that that dividend's gonna be able to grow long term. If anything, it may be a candidate to be cut.

So that is our first example. And we've never owned Kraft. Fortunately, the return on invested capital kept us out of it. I'm not second-guessing Warren Buffett. Just couldn't see the catalyst for things to get better, so we stayed away from it.

The next one, this one I find kind of fascinating because according to the numbers, it's kind of hard to figure out why it's worked, but it has worked. Let's pretend that we invested the first of January in 2000 and put $10,000 in the Southern Company. It's a utility. If you would've done that, the S&P 500 over that period of time, total return, $77,000. Total return in the Southern Company is $124,000. It is the opposite of Kraft. You've had a great performing stock here.

Well, we've never been big utility buyers. We own very few of them. And here's the part that gets really intriguing to me. The average return on invested capital for Southern Company for the last 26 years has been approximately 6%. It is currently 4%. The stock has performed much better. The returns are much higher, but the return on their capital barely pays the debt costs, and this shows up in return on assets. The average has been about 4%. It's currently 3%, so their total asset base kind of confirms the invested capital number.

The returns are not that high, and part of the problem is it's a regulated business. At this point, you may be saying, you know what, what is this here? Is this some kind of stock market manipulation? Well, we'll go to the third number, return on equity. Utilities are leveraged fairly extensively, and they do have relatively cheap debt that helps pull out a return that's a little bit more competitive to the equity holders. And the average here is 12% over this 26-year period. Currently, it's 11.5%. So that is part of the explanation of why Southern Company has been a great investment.

I think another piece to it, there's a couple of them. In the last few decades, we've been in a steadily declining interest rate market. These utilities tend to trade a little bit more like bonds because they are basically bought for their dividends. You had great performance off of that. And now, even though interest rates have moved up a little bit, utilities are very popular with the whole AI trade.

So it's probably a semi-complicated story. There's never one number that's just gonna tell you everything you wanna know. Low return on invested capital completely didn't work for Kraft, and for Southern Company to date appears to really not make any difference. The point of this, hopefully, is how this gets applied company by company.

So now we're gonna go to one that you are well familiar with, but this has a slightly different spin. We're gonna go to our old friend Williams-Sonoma. If you go back, total return from January of 2000 to now, S&P 500 up $77,000. Williams-Sonoma up $296,000. It's actually double what Southern Utilities has done.

We bought it in October of 2022 for $58. It's now $208 over the period that we've owned it. Revenue is down slightly. Net income is flat right there. You're wondering, how in the world did we make over three times our money?

Here's the first hint. Return on assets in 2000 was 10%. They basically have averaged 10%. Currently, it's 21%. So their asset base, they have a good return on it. If you look at equity, which they have very little debt, but return on equity in 2000, it was 20%. It's averaged over that 26-year period, 30%. The current return on equity number is 54%. This thing has been very shareholder-friendly.

Our trusty friend, return on invested capital: in 2000, it was about 17%. It's averaged probably about 20%. Currently, it's 32%. They've been able to maintain margins. They've actually improved them a little bit. They've managed the balance sheet extremely well. They've bought back stock. They have not gone out and bought any companies and diluted the balance sheet.

The dividend has grown just in the four-year period from $1.56 to $2.64, which is up 70%. And with the profitability that these guys have, even though the stock's not cheap, it's why we still have part of the position in it. There's different ways to create value: stock buybacks, growing the dividend, reinvesting in the business. And management has not relied on financial engineering to drive returns, and they show every ability to continue to grow the dividend relatively aggressively.

It's just a great example of very clean, somewhat simple businesses can still generate great returns.

I mean, Williams-Sonoma was good, but now we're gonna move to the last one. Guess what has been better? Microsoft. A lot of clients own it. It is not in the model portfolio. Wish it was, but it's not. This was bought before our model portfolio started. We bought it in June of oh six.

If you put $10,000 in June of oh six, it's worth $297,000. The S&P 500's worth $79,000. So remember on the other examples, I was using 2000. This is six years less, and it's got a higher return.

However, this is not gonna play out quite the way you think. If you look at what the stock did for the first several years we owned it, in 2006 through 2011, the stock moved very little. Return on invested capital in June of oh six was 28%. In the 2015 to 2017 period, it actually dropped below 10%. The average over this 20-year period has been about 30%. It's currently 24%, so it's actually declined a little bit from where it was in 2006.

Return on assets in June of oh six, it was 18%. 2015 to 2017, it dropped below 10%. Currently, it's 18%. So it's roughly the same as where it was in 2006.

Here's been the beautiful thing of this company. One of the reasons why it's performed so well is what that tells you is the balance sheet has grown dramatically, and they basically have been able to do it close to the same profitability. I mean, that is a dream come true.

Looking at return on equity, it was 28% in June of oh six. It dropped a little bit below 15% in 2015 to 2017. Right now, it's 32%. Return on equity is a little bit higher because Microsoft does use a little bit of leverage. Now, on a net basis, they have plenty of cash to pay off all their debt, but they have a slightly bigger balance sheet because of it.

From 2016 to currently, revenue has grown from $44 billion to $281 billion. Net income has grown from $12 billion to $104 billion. And they've done it at virtually the same profitability. The dividend when we bought it was 36 cents. Now it's up to $3.64. It could be very easy for them to transition this into a 3% or 4% dividend payer and make no difference in what capital they need for their business.

So the conclusion with Microsoft is, for the first several years, it was a business that couldn't really do a whole lot with very strong cash flow. But then over time, high return on invested capital gives you options. Some companies don't make good choices. Other companies do. Microsoft was one that did. They eventually transitioned into taking that very profitable business, and they were able to start reinvesting it at similar rates of return.

It's like, holy cow, if you can find a handful of these and you let compounding work in your favor, really big things start to happen. And it's why the stock has done so well.

Now, there is one piece that is extremely important. It sounds like I'm preaching for return on invested capital, that it's the savior of the investment world. Well, it's not. One thing that you really want to try to pay attention to, and we actually follow, is looking at the incremental return because return on invested capital is backward-looking.

If you look at their asset base and they grow the asset base by 10% and they're able to grow net income by 10%, you want them to be able to generate the same returns or close to it. If they're earning more than their cost of capital, then over time they should create shareholder wealth. But as a few of these examples have shown us, it's never totally that simple.

All things can be manipulated. What you don't know on just the simple return on invested capital number is where the returns are coming from. Is it coming from one division specifically? Is it more diverse through the company? Companies can avoid investing their capital for growth and conserve cash that way, which can potentially hurt their long-term growth down the road. Asset-heavy companies, in order to try to pump up their profitability, they can underinvest in maintenance. That's an issue that you really have to pay attention to in the railroads. It's really big in airlines. And things that are more asset-light are, by very nature, all things equal, gonna have higher return on invested capital numbers.

Every company that you look at is gonna be a moving target. It evolves over time and where they allocate their capital, but it's extremely important, if you're going to manage these individual equities on your own, to try to get some handle on where returns are coming from and how they're gonna continue to drive it.

Long term, companies say one thing and do another. And if there's one single thing that'll kill it more than anything, it's an acquisition.

So as we wrap this up, if we had to pick one number, it would probably be return on invested capital. No number's perfect, but it is a fairly good one that basically equalizes everything else. It helps us focus on whether a company is actually creating value over time, which is what ultimately supports long-term dividend growth. That's why we like it. They really are connected pretty much one-to-one.

What makes these companies work is they're well-run businesses. They're profitable. They stay profitable over time, which allows ’em to grow their dividend. It's almost that simple. The part that's not simple is these companies are constantly evolving. Managements change. Managements get into different mindsets. It's all something that you have to pay attention to.

So if there's one thing that we really try to remind you of in this podcast, and even ourselves, it's not about one year. It's about a decade. It's about two decades, because that's where all the wealth is created. The underlying core is that the economy grows over time, and great businesses create value for a long period of time.

If you enjoyed today's podcast, please leave us a review and subscribe. If you would like more information regarding dividend growth or our investment strategy, please visit growmydollar.com. There you'll find previous episodes and also our monthly newsletter. If you have any questions or anything to add to today's episode, please email ethan@growmydollar.com
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Past performance does not guarantee future results. Every investor should consider whether an investment strategy is right for them and all the risk involved. Stocks, including dividend stocks, are volatile and can lose money. Denewiler Capital Management may or may not have positions in the publicly traded companies mentioned herein.