In this series on the Dividend Growth Investing (DGI) strategy, we discussed the ideas behind the approach, how to find investment ideas and qualitative considerations. In Parts 4 & 5, we’ll look at Dividend Growth Investing valuation and how to determine the intrinsic value.
Why is Intrinsic Value Important?
A company’s price is readily available from the stock exchange. However, unless the investor knows the underlying intrinsic value of a company, the fairness of the price is unknown. Is it a bargain, reasonably priced, or overpriced?
Price is what you pay, and value is what you get. And, investing can only be done in an intelligent and disciplined manner with an estimate of the value. Intrinsic value is your edge as an individual investor helping to protect you from errors.
Great business can Temporarily go on sale
Even the best companies do not perform well all the time. Perhaps the industry is experiencing a downturn or at the bottom of the business cycle.
Reliable records of capital allocation can get blemished with a wrong investment decision or acquisition. Is this a temporary misstep with a reasonable likelihood of recovery or the beginning of a permanent decline?
Is this an opportunity for the individual investor to purchase a great business temporarily on sale?
“Never is there a better time to buy a stock than when a basically sound company, for whatever reason, temporarily falls out of favor with the investment community.” – Geraldine Weiss
A Dividend Growth Investment strategy combined with a buy low and sell high mentality can compound returns even further provided management delivers a recovery.
Combining Dividend Growth Investing with a value investing approach can create attractive returns over the long term. But, it requires knowing Dividend Growth Investing Valuation.
It is crucial to understand the potential for positive change based on research. Do you have the time? And are you willing to spend it to research these situations?
Estimating Total Returns
The total return on Dividend Growth stocks is a combination of the current yield and future dividend growth. The dividend yield (income) contributes about 43% to the total return from Dividend Growth Investing. Share price appreciation makes up the remaining 57%.
The formula to estimate the total return is:
Total return = % dividend yield + % dividend growth rate.
Dividend Growth Investing Valuation
The bulk of total return from Dividend Growth Investing comes from appreciation and appreciation is estimated with valuation. Let’s look at three methods to do that.
1) Dividend Yield Valuation
Legendary investor Geraldine Weiss popularized a simple and successful valuation method known as the dividend yield theory.
It is successfully used with stocks of the highest quality and at a low price relative to its historical performance. These stocks tend to have a lower risk of declining in price and high potential for capital gains and dividend increases.
“To save time and turmoil, to pave the way to profits and, most of all, to minimize risk, the dividend yield theory should be applied only to the most prosperous and progressive corporations on the stock exchanges – the blue chips.” – Geraldine Weiss
The idea is to buy when a high-quality stock is within 10% of the highest historical dividend yield or the highest in five years. And, sell when it is within 10% of its lowest historical dividend yield or the lowest in five years.
High-quality Dividend Growth stocks tend to be stable and fluctuate around a yield representing its underlying investment characteristics and fair value.
Deviations from that fair value will eventually revert to the mean because of the stable nature of the company.
Dividend Yield Theory in Practice
An excellent newsletter using the Dividend Yield Theory among others is Intelligent Income by Simply Safe Dividend of which I am a subscriber. Let’s look at their analysis of A.O. Smith company as an example of applying this valuation method. AOS is a Dividend Aristocrat with 25 consecutive annual increases.
They wrote: “… The firm last raised its dividend by 22% in October 2018 and maintains excellent dividend growth potential going forward. A.O. Smith’s payout ratio sits below 35%; the business has a pristine balance sheet (more cash than debt). Management targets 8% long-term organic revenue growth. And the water heater replacement business generates consistent cash flow.”
And they concluded: “While A.O. Smith’s short-term outlook is murky; I continue to believe this is a great business to own for the long term. The company’s strong market share, 85% replacement market in U.S. water heaters and boilers (recurring cash flow), solid organic growth, and excellent balance sheet will allow A.O. Smith to successfully navigate volatile times.”
When the yield is high, the price is low and when the price is high, the yield is low. This provides the Dividend Growth Investor with value-based buy and sell signals.
However, once purchased at a fair price, there is usually no need to sell these high-quality stable stocks. That’s because these companies provide the necessary products and services needed by modern society even during recessionary periods.
The dividend yield is a valuation method that generated better returns than the S&P 500 index, and Warren Buffett’s Berkshire Hathaway returns from 2000 as discussed here.
2) Dividend Discount Model Valuation
Another useful valuation is the Dividend Discount Model (DDM).
The DDM determines the value of a stock based on future annual dividend payments. It assumes continuous dividend payments made with a constant rate. The present value of all the future dividend payments is the intrinsic value of the stock.
The underlying assumption is the constant growth rate of the dividends. So, this formula applies to established and stable companies. Developed by Professor Myron Gordon, it is known as the Gordon Growth Model.
Since Dividend Growth investors buy a stream of future dividend payments with their investment, it makes sense to value the stock as the sum of all those future payments.
The Dividend Discount Model Formula
The value of a stock consistently paying a dividend uses three readily available variables:
- D = next year’s annual dividend payment
- r = the discount rate
- g = the constant growth rate for dividends, in perpetuity
Using these variables, the DDM equation is:
Value per Share = D / (r – g)
Next Years Annual Dividend
Increase the current year dividend by the anticipated annual growth of the dividend.
The discount rate is the minimum return required from an investment. Think of the discount rate as the “opportunity cost,” you could earn if you choose another investment.
For example, if the alternative is investing in bonds paying 5% interest per year, the opportunity cost (discount rate) is 5%. That’s what is forgone by not buying the bond to buy the dividend-paying stock. The discount rate would be 10% if the alternative investment would return 10% per year.
Constant Growth Rate for Dividends
The dividend payment history of high-quality dividend companies could indicate the future dividend growth level. In addition, some companies state a target goal for dividend increases.
Let’s Work Through an Example
Brookfield Infrastructure Partners (BIP) has a targeted distribution increase of 5% – 9% growth annually. The current dividend is $2.01 per unit, and it trades at $44 per unit yielding about 4.6%.
Let’s assume the 7% midpoint of the targeted distribution increase each year. So, next years annual dividend (D) will be $2.15 per unit ($2.10 x 1.07 = $2.15).
Let’s also assume an alternative investment, investing in an S&P 500 index fund, would return a total of 10% per year. So that is the opportunity cost or discount rate (r) for this investment.
Value per Share = D / (r – g)
Substituting these values into the above formula gives us:
- Value per Share = $2.15 / (.10 – .07)
- = $2.15 / (.03)
- = $71.66
In this estimate, the 7% midpoint dividend growth rate is assumed to continue forever and results in an intrinsic value of $72 per share. Try it yourself, do you get the same answer?
Since BIP is selling at $44 per unit and the intrinsic value is estimated at $72 per unit it is an attractive investment with a 39% margin of safety (1 – (44/72)) x 100 = 39%.
Now let’s assume an investor has a required rate of return of 12%. Using the estimated dividend of $2.15 for 2020, the investor would use the dividend discount model to calculate a per-share value of $2.15/ (.12 – .07) = $43.00. In this case the investment is still attractive providing the investor with a return very close to the required 12% per year.
Notice how a small change in the discount rate, from 10% to 12%, makes a large change in the calculated value (from $72 to $43).
What we have learned:
- Price is what you pay, and value is what you get.
- Intelligent and disciplined investing requires an estimate of value.
- Dividend Yield Valuation works with high-quality dividend stocks.
- Dividend Discount Model Valuation works with constant dividend growth.
- Valuation Models are sensitive to small changes in the assumptions used.
In Part 5, we’ll look at the third valuation method, Multi-Stage Dividend Growth Valuation for stocks with variable dividend growth stages. And, wrap up this Dividend Growth Investing series.