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Many investment pundits are making the case that dividend stocks are in a bubble. I believe they are wrong.

The bubble argument begins and ends with investor enthusiasm for income. As the argument goes, the massive flows into dividend stocks (and other income vehicles) are a tell-tale sign of herd behavior. Pointing to bubbles past, the argument suggests that dividend stocks will collapse when investors rush for the exits. The catalyst they point to is rising interest rates.

Wrong, wrong, wrong.

I believe dividend stocks - in general - are not in a bubble for the following reasons:

1. Valuations

By segregating non-dividend payers and dividend payers within the S&P 500 Index (SPY), I was able to provide context to valuations for dividend payers. After separating the two categories of stocks, I then calculated the average P/E ratio, forward P/E ratio and P/S ratio for each.

Note that these category averages are calculated by weighting each S&P 500 constituent equally, whereas calculations made by S&P on the index are weighted by each company's presence within the index. I believe my methodology is superior because it doesn't overweight data simply based on a company's historical success at growing market capitalization.

When averaging the category data, I decided to exclude Amazon (AMZN) from the list of non-dividend payers since its super-high valuation skewed the data considerably.

The results are shown in the chart below. As you can see, the average P/E ratio for non-dividend payers is almost twice that of dividend payers. We see a similar result for Forward P/E and P/S ratio.

To account for remaining skewness in the data, I also calculated the median P/E, Forward P/E and P/S ratios. We see a similar result: median P/E, Forward P/E and P/S ratios are all higher for the non-dividend paying category.

Within the dividend payer category, there are 188 stocks with Forward P/E ratios of 10 or less. These 188 stocks had an average dividend yield of 2.78%. Within this group, there were several prime examples of dividend payers trading at a cheap valuation:

  • Caterpillar (CAT): 2.44% Yield / Forward P/E of 9.81
  • Wells Fargo (WFC): 2.67% Yield / Forward P/E of 9.09
  • Chevron (CVX): 3.41% Yield / Forward P/E of 8.65
  • Microsoft (MSFT): 3.46% Yield / Forward P/E of 8.22

Compare these valuations to those of stocks during historical bubbles, such as the tech bubble of the late 1990s which saw P/E ratios reach the hundreds, justified using new metrics like 'eyeballs' and 'clicks'.

(click to enlarge)

2. Payout Ratios

Payout ratios are low-moderate relative to historical ratios, depending on how you view the metric. Within the dividend payer category I created using S&P 500 data, the average payout ratio is 62.69%. This is a reasonable payout ratio. In other words, companies that pay dividends aren't doing so to the detriment of their own operations. Including all S&P 500 constituents, the average payout ratio falls to 52.39%.

How does today's payout ratio compare with history? To get a longer time-series, I had to switch to a market cap-weighted methodology due to data availability.

The following data shows the dividend payout ratio for the S&P 500 dating back to 1871. While the payout ratio is quite volatile over time (because earnings tend to be cyclical), a clear downward trend is illustrated by the straight black trend-line. This suggests that, in addition to being at reasonable levels today, payout ratios are historically low and have room to rise. If current levels are reasonable and payout ratios have room to rise, today's dividend yields are not stretched and dividend stocks are not in a bubble.

(click to enlarge)

3. Interest Rates

Interest rates are historically low and probably aren't getting any lower. Some believe that interest rates will soon rise, shrinking the present value of fixed cash flows such as dividends and coupons. In my opinion, the assumption that interest rates will skyrocket at any moment is a fallacy.

Frankly, the economy couldn't handle much higher interest rates and central banks are pressing all the right monetary buttons to keep rates low.

Some argue that we are in a period of 'financial repression' like that of the late 1940s to late 1950s. During this period, interest rates were kept artificially low for an extended period to help the US government extinguish the real value of public debt accumulated during the Great Depression and World War 2. History shows that interest rates can remain low for a very long time. If the same scenario were to play out today - and many argue that it will - rising interest rates won't be a negative catalyst for dividends anytime in the near future.

4. The Dividend Bubble Paradox

My final point is more of a question. One characteristic of a bubble is that stock prices are bid up to astronomical levels. As stock prices are bid up, dividend yields would shrink. Therefore, if dividend stocks were really in a bubble, wouldn't yields shrink by such a degree that nobody would really consider them dividend stocks anymore?

Conclusion

Despite the talk about dividend stocks being in a bubble, I think each stock should be reviewed under its own merits. There is plenty of evidence suggesting many dividend stocks are quite cheap, and I certainly wouldn't avoid dividend stocks by naively accepting broad generalizations.

Source: Are Dividend Stocks In A Bubble?

Additional disclosure: Data Sources: Finviz, Robert J. Shiller. This is not advice. While the author makes every effort to provide high quality information, the information is not guaranteed to be accurate and should not be relied on. Investing involves risk and you could lose all your money. Consult a professional advisor before making any investing decisions.