04-05-2013, 08:20 PM
With dividend growth investing, the focus is on generating a steadily growing income stream by purchasing stocks that pay an increasingly large dividend each year. In this series of posts, I have focused on many of the important factors to consider in evaluating such stocks, including the number of years the company has raised its dividend, the current dividend yield and dividend growth rate, the payout ratio, and the rate of earnings growth. So if you found a stock that scored highly in every single one of those categories, it would be a great buy, right?
Not necessarily. It is possible to overpay for even the best company or for the most robust and growing income stream. How much you pay for a stock is a critical determinant of whether the investment will turn out poorly or well in both the short and long term. There are two primary reasons to look for quality dividend stocks that are also trading at a good value.
The first reason is that when a quality dividend stock is trading at a lower value, you have a chance to buy the stock’s dividend at a higher yield. A company’s stock price constantly fluctuates, both before and after you buy your shares. But the share price at the moment of purchase determines your yield for that stock. If you buy one share of a company for $100, and that company currently pays $3.00 in dividends annually, your share yields 3.00 percent. If you bought that share on a dip to $90 instead, the same $3.00 dividend would translate to a yield for you of 3.33 percent. If you bought the share on a spike to $110, your yield is only about 2.73 percent. Those may not seem like big differences, but over a long time period, they can be truly huge.
The second reason is that when you buy your shares at a lower price, you improve your chances of enjoying significant capital appreciation. While a solid dividend stream can cushion the blow of a declining share price, it is far better to enjoy that dividend stream on top an increase in the underlying share price. (Although there is room here for a lengthy discussion about whether you should root for stock prices to increase or decrease during your accumulation years, I’ll save that for another thread.)
There are many ways to measure the value of a stock. And smart people argue all the time about whether a particular stock is overvalued, undervalued, or properly valued. It can be maddening, unless you understand that there truly is no “right” or “correct” price for a stock. If it were easy to determine the “right” price for a stock, there would be no trading and no market – who would pay more or less for it? Instead, we have countless opinions about a stock’s worth that fluctuate over time, and people who think that a stock is overvalued at the current price sell their shares to people who think it is a reasonable or good buy at the current price.
The 800-pound gorilla in the valuation conversation is the P/E ratio, which is simply dividing the current price by the earnings. While the current price is easy enough to ascertain, earnings can be more slippery. Not only are earnings somewhat subjective, depending on how the company calculates and reports, but you must also decide which earnings to use. Last full calendar year? Trailing twelve months? Projected? Personally, I look at all of these to get a rough sense of where the P/E number is and where it might be headed. People will argue, perhaps correctly, that there are many more sophisticated ways to measure the value of a stock (price to sales, price to book, historical price and moving averages, technical, etc.). My opinion is that P/E works well enough in providing a rough idea of the valuation of a stock, especially when used in conjunction with the other entry criteria we’ve been discussing.
So what is an appropriate P/E ratio? As usual, it depends. “Typical” P/E values differ from month to month, from industry to industry, and from stock to stock. When the economy is booming and stock prices in general are rising, P/E ratios are higher than when the economy is stalling and stock prices are down. Stocks in mature, slow-growth industries (such as oil companies) tend to have lower P/E ratios than stocks in exciting new growth areas (think internet stocks back in the late 1990s). And a blue-chip stock that has steadily growing earning and dividends, a premium brand name, and that is not very volatile will generally have a higher P/E ratio than its lesser-regarded industry peers.
When assessing valuation, it is good to get a feel for how a particular company trades over a long period of time. If a stock usually trades around a P/E range of 12 to 15, but currently has a P/E of 9, it pays to understand why. If the company’s fundamentals are sound and the price is down primarily because of broad economic conditions, it might be a great time to buy. If the reasons for the P/E drop are specific to the company, the lower P/E could be a red flag.
Many dividend growth investors will not buy a stock with a P/E ratio above 20. While I don’t believe in hard and fast rules of this sort, I don’t think that I own any stock with a P/E of 20 or higher, and I prefer a P/E of 15 or lower. But again, this is only a guideline, and only one of many factors to consider.
In the next, and final, installment of this series of posts, I’ll talk about various intangible factors that I consider before investing in a DG stock.
Not necessarily. It is possible to overpay for even the best company or for the most robust and growing income stream. How much you pay for a stock is a critical determinant of whether the investment will turn out poorly or well in both the short and long term. There are two primary reasons to look for quality dividend stocks that are also trading at a good value.
The first reason is that when a quality dividend stock is trading at a lower value, you have a chance to buy the stock’s dividend at a higher yield. A company’s stock price constantly fluctuates, both before and after you buy your shares. But the share price at the moment of purchase determines your yield for that stock. If you buy one share of a company for $100, and that company currently pays $3.00 in dividends annually, your share yields 3.00 percent. If you bought that share on a dip to $90 instead, the same $3.00 dividend would translate to a yield for you of 3.33 percent. If you bought the share on a spike to $110, your yield is only about 2.73 percent. Those may not seem like big differences, but over a long time period, they can be truly huge.
The second reason is that when you buy your shares at a lower price, you improve your chances of enjoying significant capital appreciation. While a solid dividend stream can cushion the blow of a declining share price, it is far better to enjoy that dividend stream on top an increase in the underlying share price. (Although there is room here for a lengthy discussion about whether you should root for stock prices to increase or decrease during your accumulation years, I’ll save that for another thread.)
There are many ways to measure the value of a stock. And smart people argue all the time about whether a particular stock is overvalued, undervalued, or properly valued. It can be maddening, unless you understand that there truly is no “right” or “correct” price for a stock. If it were easy to determine the “right” price for a stock, there would be no trading and no market – who would pay more or less for it? Instead, we have countless opinions about a stock’s worth that fluctuate over time, and people who think that a stock is overvalued at the current price sell their shares to people who think it is a reasonable or good buy at the current price.
The 800-pound gorilla in the valuation conversation is the P/E ratio, which is simply dividing the current price by the earnings. While the current price is easy enough to ascertain, earnings can be more slippery. Not only are earnings somewhat subjective, depending on how the company calculates and reports, but you must also decide which earnings to use. Last full calendar year? Trailing twelve months? Projected? Personally, I look at all of these to get a rough sense of where the P/E number is and where it might be headed. People will argue, perhaps correctly, that there are many more sophisticated ways to measure the value of a stock (price to sales, price to book, historical price and moving averages, technical, etc.). My opinion is that P/E works well enough in providing a rough idea of the valuation of a stock, especially when used in conjunction with the other entry criteria we’ve been discussing.
So what is an appropriate P/E ratio? As usual, it depends. “Typical” P/E values differ from month to month, from industry to industry, and from stock to stock. When the economy is booming and stock prices in general are rising, P/E ratios are higher than when the economy is stalling and stock prices are down. Stocks in mature, slow-growth industries (such as oil companies) tend to have lower P/E ratios than stocks in exciting new growth areas (think internet stocks back in the late 1990s). And a blue-chip stock that has steadily growing earning and dividends, a premium brand name, and that is not very volatile will generally have a higher P/E ratio than its lesser-regarded industry peers.
When assessing valuation, it is good to get a feel for how a particular company trades over a long period of time. If a stock usually trades around a P/E range of 12 to 15, but currently has a P/E of 9, it pays to understand why. If the company’s fundamentals are sound and the price is down primarily because of broad economic conditions, it might be a great time to buy. If the reasons for the P/E drop are specific to the company, the lower P/E could be a red flag.
Many dividend growth investors will not buy a stock with a P/E ratio above 20. While I don’t believe in hard and fast rules of this sort, I don’t think that I own any stock with a P/E of 20 or higher, and I prefer a P/E of 15 or lower. But again, this is only a guideline, and only one of many factors to consider.
In the next, and final, installment of this series of posts, I’ll talk about various intangible factors that I consider before investing in a DG stock.
