Stock Valuation Discussion

[Dividend Watcher]

Rob, that IS a great question. I still wrestle with it all the time.

First off, to answer your dilemma, I don't think you can come up with a consistent method of valuing where you should buy and/or sell. Just as there are growth, value and cyclical companies (and hence the stock), there are different ways of valuing a company. Chuck Carnevale alluded to this with his method of fixing a "True Worth" line in FAST Graphs. Simplistically, for slower growers, he uses a P/E of 15; faster growers get a PEG for True Worth, etc. There's a reason he calls it a "tool to think with".

Then there's the actual P/E line of what investors were willing to pay in the past. That is where I usually shoot for but even that is not set in stone. Since I don't subscribe to any pay newsletters or tools, I use what's available to me.

I use the S&P stock sheet from TDA to come up with a 10 year average P/E. To that I add a DCF calculation from moneychimp.com. I also use the modified Graham formula for instrinsic value (the one using long-term bond rates). I also look at the stats such as the Chowder Number in the CCC spreadsheet.

Of course, the Discounted Cash Flow and Dividend Discount Models are very sensitive to the assumptions you use and seem to vary all over the place with with a small change in the input. I just don't trust them as much.

Then I look at the financials. Of course I'm looking for low debt, steady (and preferably higher) growth, a good dividend that grows, etc. but there's an exception to every rule. Look at CLX and LMT. They have very high debt yet they keep pumping out the earnings and dividends. GIS hasn't had a current ratio above 1 for years yet they keep paying their bills and hasn't ever cut its dividend for almost 100 years.

I also look at some of the analysts reports -- S&P, Credit Suisse, Ford. They have someone who's followed the business for a while and know what events are significant for the company. I can't be an expert in every field. I do a search on SA because sometimes a non-professional's views bring out something I could key on. KO is a prime example. David Crosetti has mentioned several times he was never sure what KO should be selling at but whenever the yield got to 3%, it was a good time to buy. I bought it for my wife's portfolio blindly when it last dipped to bring the yield to 2.92% and the P/E was somewhere between 19.99 and 20.02 (I can't remember exactly). I was counting on this next dividend increase to bump the yield to over 3%.

As to dividend growth rate, I like it to be somewhat consistent. At least not a steady decline in most cases. For example, 1Y DGR=3%, 3Y=5%, 5Y=8% and 10Y=12% won't do it for me without the company radically changing its business model within the last few years. However, a 1Y=6%, 3Y=8%, 5Y=12% and 10Y=17% would work. If you look at Robert Allen Schwartz's web site, dividend growth rates over 6-8% over the long term are very hard to sustain. But, you never know. Look at MMM's last dividend increase ... over 30%. Yowza! Talk about kicking yourself in the arse after selling it at breakeven (about $78) in the Great Recession. Yield and growth had gotten too low for me. This was one of my pre-DGI purchases (the old me) and let emotions get the best of me.

Lastly, I look at a price chart just to see if there's a trend over the last few months. If there's that characteristic exponential curve going up without a corresponding exponential increase in earnings or a big jump, I tend to stay away. Nothing stands out in my mind specfically but look at GOOG (P/E over 30 right now) over the last couple years or the gold (not that I'm a gold bug) curve a few years ago.

All that being said, I do have a few "rules":

1. Never buy a stock with a P/E over 20 although I prefer under 18. Despite temptation at times, I've been able to stick to this pretty much.

2. Yield should be over 2.5% at time of purchase. The lower the yield, the higher the dividend growth rate.

3. Has to be on the CCC list because I do want the dividend growth.

4. Shoot for a P/E at or below the 10 year average P/E.

Sometimes I want a stock that's a hair over my limits as in your KMB case. In those circumstances, I'll purchase a small position (1/4 or so) just as a placeholder in the portfolio and to get the dividend compounding ball rolling. This forces me to watch the stock closer and, when I think it's a real value, buy a bunch more.

Clear as mud, I know. If you thought Kerim's answer was rambling, I don't know what you call this.