To combat the recent wave of pundits calling a "bubble" in dividend paying stocks, I recently wrote an article highlighting why I believe dividend stocks are not in a bubble.
In that article, one of my arguments compared the valuations of dividend paying stocks and non-dividend paying stocks. While this provided a broad comparison, one reader emailed me a poignant thought:
The valuation comparison between dividend paying and non-dividend paying companies may be skewed because many non-dividend paying companies are growth companies that have yet to achieve a consistently positive cash flow. In other words, the comparison isn't necessarily fair.
Perhaps a better comparison would be to isolate companies that pay dividends and illustrate the valuation difference between companies that pay relatively little and relatively a lot of their earnings in dividends.
I felt the reader's point was important to address. That is the purpose of this article.
While there are a few ways one can distinguish between stocks that pay dividends, I decided to categorize based on payout ratio. The rationale is that the payout ratio is a rough measure of dividend policy. And, in my view, it is the philosophy behind the policy of paying steady dividends that many investors seek when investing in dividend stocks. This philosophy is one of conservatism and discipline.
A board of directors that is committed to distributing a portion of earnings to shareholders is one that is less likely to permit negative NPV projects, such as management empire building. By forcing management to focus on only the best projects, this philosophy is one that supports long-term shareholder value.
More specific to the question of overvaluation, however, is whether or not investors are rewarding companies that stretch their dividend policy beyond reasonable levels.
The idea of a dividend bubble is one centered around the chase for yield. And in the chase for yield, one could argue that investors will reward companies that pay out as much as possible with higher valuations.
The reason I did not use yield itself as the measure of evaluation is that yield gets compressed as dividend stocks with high payout ratios (in theory) are bid up. Regardless, my results show that yield is more or less positively correlated with payout ratios.
The chart below summarizes the research I performed.
I first grouped the dividend-paying constituents of the S&P 500 (SPY) by payout ratio ranges (first column). To give a sense of what each payout ratio bracket contains, companies with payout ratios <50% include Microsoft (MSFT), Caterpillar (CAT), Chevron (CVX), Intel (INTC), Lockheed Martin (LMT) and Home Depot (HD). Stocks that had payout ratios over 100% included a few REITs and other companies like Health Care REIT (HCN), Host Hotels & Resorts (HST), Verizon (VZ), AT&T (T) and Kinder Morgan (KMI).
Despite my earlier observations in my previous article, linked above, when comparing the aggregate dividend payers vs. non-dividend payers categories, which concluded that dividend stocks weren't in a bubble, the table below shows that there may be a valuation change based on payout ratios.
In particular, as payout ratios rise, so do dividend yields and valuations. In fact, on average, stocks with payout ratios over 100% are "rewarded" by the market with P/E ratios that exceed non-dividend payers (as calculated in Part 1 as 21x). A similar observation can be made in the chart below for Forward P/Es and P/S in columns 4 and 5.
|Payout Ratio Range||Dividend Yield||P/E||Forward P/E||P/S|
Data source: Finviz
What is an investor to take away from this?
Those following along are probably understandably confused. In my first article, I said dividends weren't in a bubble. Does this article contradict the first? Not necessarily. I consider the conclusions of this article a refinement of the conclusions in Part 1.
Clearly, there is a difference between stocks with low and high dividend payout ratios. In my opinion, it appears that investors are in fact chasing riskier yields, as demonstrated by the steep valuation increases for stocks with payout ratios over 100%.
This analysis shows that within a broad category, there can be wide variations in terms of valuation. While stocks with high payout ratios may be richly valued, conservative dividend payers -- those with payout ratios below 75% -- are trading at reasonable valuations. In fact, dividend stocks with payout ratios below 75% make up 80% of the universe of dividend stocks within the S&P 500. So while there is a valuation creep for stocks with higher payout ratios, it still appears that this is the exception to the norm.
Finally, while the dividend yields on dividend stocks with payout ratios below 75% may not be as juicy, one must realize that there are tradeoffs when chasing big yields. Moreover, investors shouldn't view dividend yields in isolation, and instead, should focus on the totality of returns: capital gains + dividend income. Often it is the growth of the latter that drives the former.
Additional disclosure: Data Source: Finviz. 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.