Payback is the amount of time needed for an investment to earn its cost, undiscounted. Years ago as a young analyst, I was assigned the project of streamlining my employers' acquisition model. As part of this project, I removed the payback calculation. The company's focus was on discounted cash flow and internal rate of return, so I didn't see the need for a payback metric. No one noticed the missing payback calculation, that is, no one except the CEO.
Needless to say, I was a little nervous making the long walk to the corner office to explain why I had removed a metric that he considered both beneficial and important. The CEO's background was not financial, but he had a keen understanding of finance. He was kind in his explanation of how he used payback.
When looking at a 40 year project with literally hundreds of assumptions, payback helped him gauge the risk of missing those assumptions. If the assumptions were little aggressive and the payback was 20 years, the project's sponsor would get a lot of tough questions. A shorter payback and less aggressive assumptions normally indicated a lower risk project.
Applying payback to dividend growth stocks is a little more complicated due to the annual dividend increases. Nothing that can't be quickly modeled in a spreadsheet. Payback is one of the metrics tracked in my database. Companies with a very short payback are often troubled or have been highly discounted due to the market's lack of faith in them. At the other extreme, do you really want to wait 30, 40 or 50 years to earn back your initial investment? As a compromise, a 9 to 13 year payback should be acceptable for most long-term investors.
Once you earn back your investment, some might say you are in a no-lose situation. I wouldn't go quite that far, but you do have an investment that that has provided a good historical revenue stream, and hopefully it will continue to do so in the future.
This week week, I screened my dividend growth stocks database for select stocks with a 10 to 13 year payback (at the current yield and dividend growth rate) and yield of 3% or more.