This article concludes the five part series on Dividend Growth Investing. It looks at a third valuation method for stocks with variable dividend growth stages. Then it provides the Dividend Growth Investing summary, and suggested resources for further use.
In Part 4, we introduced valuation and suggest that investing can only be done in an intelligent and disciplined manner with an estimate of the company’s value.
The Intrinsic value is the individual investor’s edge. Price is what you pay, and value is what you get. The onlyway to know if you get what you pay for is to know the underlying value of the company.
Let’s discuss the third valuation method, the Multiple-Stage Dividend Discount, first. Then follow that with the Dividend Growth Investing Summary. Recall the Three Dividend Growth Valuation methods covered in this series are:
- Dividend Yield Valuation here
- Dividend Discount Model Valuation here
- Multiple-Stage Dividend Discount Valuation (below)
Multiple-Stage Dividend Discount Valuation
The Multi-Stage Dividend Growth Model considers variable dividend growth stages in the valuation of a company. It is useful when a company’s dividend growth rate is subject to change over time.
A company’s earnings growth rate may slow as it becomes more significant. This slower growth rate may reduce the growth of cash available to increase the dividend.
Or, where growth is slowing the cash available for dividends may also increase. This can occur if funding is no longer needed for growth projects. And, the company decides to return the money to shareholders as higher dividend increases.
Whatever the circumstances, the Multi-Stage Dividend Discount Valuation is used to calculate the intrinsic value for variable dividend growth rates.
The dividends per share are estimated for each period and discounted back to today’s dollars. In the example below two stages are used, although any number of stages are possible.
The example assumes a company goes through a higher dividend growth stage in the early years. Then, lower dividend growth follows after the period of rapid growth.
The Dividend Discount Model (DDM) discussed in Part 4 is used for the slower growth stage. So, it now becomes the last stage in the Multiple Stage Growth Model.
The value calculated in the last growth stage is called the “Terminal Value.” The Terminal Value gets discounted back to the current valuation date.
Let’s go through an example to help make this clear.
Multi-Stage Dividend Growth Rate Model
Step 1: Determine the Value in the Growth Stage
The first step is to calculate the Present Value of the growth stage using the formula below.
- PV0 = Present Value today
- D1 = dividend per share at the end of the first year,
- Dn = dividend per share to at the end of the nth year,
- r is the discount rate or required return (the opportunity cost).
Let’s Work Through An Example
We’ll use Brookfield Infrastructure Partners (BIP) again and compare the results.
The only change is a reduction in the dividend growth rate from the midpoint 7% per year to 4% per year after ten years. All else stays the same.
- g = the 7% midpoint dividend growth rate for ten years, and a 4% stable growth rate for the stable phase after that
- r = 10% discount rate
- D1 = next year’s dividend rate is $2.15 per share.
Note: The long-term growth is assumed to be 4% and is above the World Bank’s long term 3% global GDP growth rate. This is due to the anticipated worldwide need for replacement and new infrastructure.
Use the estimated 7% dividend growth in the formula to determine the Present Value of the first growth stage. The Present Value calculated at $17.31 per unit, shown here:
Step 2: Determine the Value in the Second Stage
The next step is to determine the Value of the final stage (the terminal stage):
The Terminal Value Formula is the Dividend Discount Model formula starting in a future year:
- Dn+1 = dividend per share received the year the final growth rate starts (the 11thyear),
- r = discount rate or required return (the opportunity cost).
- g = the growth rate in the second stage.
The terminal value of the second stage is $70.49 per share.
Step 3: Discount the Terminal Value to get today’s Present Value
The Terminal Value is calculated starting in year 11. So, it is discounted back to find its Present Value in year 0 according to the following formula:
- r = is the discount rate or required return. Think of it as the opportunity cost of foregone alternative investments,
- n = is the number of years elapsed in the prior growth phase.
Calculate the Present Value of the Terminal Value.
We determine the Present Value is $27.18:
Step 4: Calculate the total Intrinsic Value
Next, add together the Present Values of the two phases to obtain the intrinsic value of the company.
Intrinsic Value Formula:
The Intrinsic Value is $44.49:
The Intrinsic Value is close to today’s price of $44 per unit. As a result, that means we can buy BIP at $44 per unit and realize a 10% annual return over the years to come.
In Part 4, where we used the Dividend Discount Model Brookfield Infrastructure Partners (BIP) calculated intrinsic value was $70.66 per share.
Consequently, with a seemingly small change in the assumption, ten years from now, we determined the intrinsic value to be $44.49 per share.
All that changed was the dividend growth rate went from 7% to 4% after year 10.
A sensitivity analysis is a tool to gain insight into how different assumptions will change the outcome.
In the example above a seemingly small change in the growth rate of the dividend ten years from now significantly changed the outcome.
The company did increase the dividend higher than 7% in recent years. As a result, an investor might also choose to run another analysis at a 9% growth rate in the first phase and 6% in the last phase.
How do you determine which of the valuation answers to use? That’s where the investor must use qualitative analysis to help make that judgment.
For example, the investor might believe that the middle class is increasing rapidly in large developing economies like India, China, and South America. It is reasonable to assume increased and/or improved infrastructure will supply the goods and services needed by this growing middle class.
The investor will not know which growth rate is the best answer for many years. However, the sensitivity cases cover a range of real possibilities. And, within this range of possibilities an investment in BIP is attractive at todays price of $44 per share.
Therefore, investing is about being approximately correct, not precisely wrong!
Dividend Growth Investing Summary
The dividend growth investing summary below highlights the topics discussed in this series with links to the respective articles.
Part 1 discussed the stock market as a great long-term generator of wealth. Above all, select an investment strategy that will work for you to capture your share of that wealth.
The idea behind Dividend Growth Investing is to create a diversified portfolio of companies capable of paying increasing dividends for long periods.
The Dividend Growth Investing strategy is for an investor seeking steady income and capital appreciation over a long-term investment horizon.
Part 2 highlighted the Dividend Champions, Contenders, and Challengers (the CCC list) as sources of Dividend Growth Investing ideas.
Starting with the CCC list and using the 10-step Guide to Stock Investments further screens the ideas using the principles of the best investors in the world.
However, remember that even with the CCC list, not all dividends are the same. Compare the Payout Ratio, Earnings Growth, and Dividend Growth to determine the likelihood of future increases.
Part 3 highlighted the growth and value paradigms of Dividend Growth Investing. And, although they get viewed as “different strategies,” at times. Many investors employ both perspectives to different degrees.
Both paradigms and some combination get us to our investing destination. That is provided the companies we buy exhibit most if not all of these essential attributes:
- They create shareholder returns;
- Run by successful management;
- With a durable competitive advantage.
- An S&P Credit Rating Above BBB-
- Low Debt to Total Capital below 50%
- Selling At or Below a Fair Value
Parts 4 & 5
In Parts 4 & 5, we moved from idea sources, implementation, and qualitative considerations to Valuation.
Price is what you pay, and value is what you get. And, investing is only done in an intelligent and disciplined manner with an estimate of the Intrinsic Value.
Intrinsic value is your edge as an individual investor for the reason that it helps protect you from the errors of buying too high and selling too low.
The three Dividend Growth Valuation methods discussed include:
- Dividend Yield Valuation
- Dividend Discount Model Valuation
- Multiple-Stage Dividend Discount Valuation
What we learned in this Series:
The Dividend Growth Investing summary below encapsulates key ideas through the series:
- Dividends and the power of compounding contributed 82% of the entire S&P 500 Index return since 1960.
- It often appeals to the conservative investors seeking to minimize risk while maximizing returns over a long-range investment horizon.
- The idea is to build a diversified portfolio of companies that are capable of paying increasing dividends for long periods.
- These are usually well managed, financially healthy, shareholder-friendly companies. Likewise, they often own influential bands names and possess protective economic moats.
- The dividend is an indicator of a company’s quality due to a history of stable returns on equity indicating superior performance.
- There is no need for high-risk investments to do well. Because the Dividend Growth Investing strategy employs an effective and cautious approach.
- The Dividend Growth Investing strategy provides an income stream that continues paying income during both bull and bear markets. The share price may fluctuate, but the dividend is generally stable even during turbulent times.
- The long-term investor also benefits from capital appreciation resulting in attractive total returns.
I hope you found this series on Dividend Growth Investing helpful.
Other valuable resources on Dividend Growth Investing:
If you don’t have the time or inclination to do your own valuations there are many helpful resources to guide you through a Dividend Growth Investing strategy. Below are some good ones:
- Dividend.com here
- Simply Safe Dividends here
- The Dividend Growth Investor here
- The Dividend Monk here