Dividend growth investing, as the name implies, involves buying the stocks of companies that consistently increase their dividends year after year. Well-known examples of dividend growth stocks are Chevron (NYSE:CVX), Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ), and McDonald's (NYSE:MCD), all of which have increased their dividends for at least 25 consecutive years. The goal of buying such stocks is to build a sustainable stream of dividends that will grow faster than inflation and serve as a reliable source of income in retirement. Naturally, dividend growth and yield are important criteria used in stock selection, but many investors also pay close attention to valuation when buying and selling stocks.

Valuation involves estimating the intrinsic value of a stock, in either absolute or relative terms, to determine whether the stock represents an attractive investment at the current price. An undervalued stock, which trades below its intrinsic value, is often seen as attractive because the discount provides a margin of safety and there is potential for capital gain if market participants eventually reappraise the stock and move its price closer to its intrinsic value. In contrast, an overvalued stock trades above its intrinsic value, provides no margin of safety, and may offer limited capital gains. Indeed, there could be greater potential for capital loss if market participants reappraise the overvalued stock in a downward direction.

Thus, valuation plays an important role in determining capital gain or loss, which is a key component of an investment's total return. However, you might wonder why valuation is relevant for dividend growth investors, whose primary focus is on the dividend component of total return. The purpose of this article is to demonstrate that valuation is very relevant because it can have strong effects on the long-term growth of dividend income.

## Long-Term Effects of Valuation Differences

To demonstrate how differences in valuation affect dividend income, I will present some numerical projections for a hypothetical stock investment. The projections are based on the following assumptions:

- There is an initial investment of $10,000 in a single stock.
- The stock's earnings are the same in all conditions and grow at a fixed rate of 5% per year.
- The stock's dividends are the same in all conditions and grow at a fixed rate of 5% per year.
- All dividends are reinvested at the end of each year at the current stock price.

I will examine portfolio value and dividend income projections over a 25-year period. The only difference between conditions will be the initial valuation of the stock and how it changes over time. I will use the price/earnings, or P/E, ratio as my valuation metric and assume that a P/E of 15 represents the stock's intrinsic or "fair" value. This implies that a stock with a P/E below 15 is undervalued and a stock with a P/E above 15 is overvalued. Of course, this is an extremely simplified and coarse-grained approach to valuation, but it will be adequate for the purposes of my examples.

In this first example, I will examine conditions in which the stock is undervalued (P/E of 11 or 13), fairly valued (P/E of 15), or overvalued (P/E of 17 or 19) at the time of initial investment (Year 0). I will look at what happens when valuation changes over 25 years to converge on a P/E of 15, as illustrated in Figure 1 (in all figures, the numbers in the legend refer to the P/E ratio at the time of initial investment):

The fairly valued stock with a P/E of 15 has no change in valuation over time. In contrast, the initially undervalued stocks undergo P/E expansion, whereas the initially overvalued stocks undergo P/E contraction. I assume that expansion and contraction each follow a linear trend and all stocks end up being fairly valued after 25 years.

What effects do these valuation differences have on the investment? Figure 2 shows how the stock price per share changes over time, which reflects the combination of earnings growth and any changes in valuation:

There are four important things to note about the figure:

- Given that all stocks have the same earnings, the undervalued stocks initially have lower prices than the overvalued stocks, which directly reflects the different P/E ratios.
- Given that all stocks converge to a P/E of 15 after 25 years, it follows that they end up at the same final price.
- Even when a stock undergoes P/E contraction, as is the case with the overvalued stocks, it can still end up with a higher stock price if the rate of earnings growth exceeds the rate of P/E contraction.
- Given that all stocks involve the same dividend amounts, the undervalued stocks initially have higher yields than the overvalued stocks.

A consequence of the first point is that the initial investment and reinvested dividends can be used to buy more shares of undervalued than overvalued stocks. When combined with the second point, this means that the undervalued stocks not only end up with larger capital gains (final price minus initial price) than the overvalued stocks, but the overall value of the portfolio is much larger. Figure 3 shows the portfolio value (number of shares multiplied by price per share) at the end of each year:

Given that all stocks have the same final price, the differences reflect the accumulation of different numbers of shares from the initial investment and dividend reinvestment. For the stock with an initial P/E of 11, the $10,000 investment is worth over $100,000 after 25 years of growth and dividend reinvestment. That is more than 50% higher than the stock with an initial P/E of 15 and more than double the value of the stock with an initial P/E of 19. These are substantial differences that hint at why value investing is a successful strategy for building long-term wealth. But it does not stop there. Figure 4 shows the annual dividend income over time, which is the focus of most dividend growth investors:

Due to a combination of dividend growth and full dividend reinvestment, there is compounding of the dividend income stream in all conditions (see this article for further discussion of compounding). However, final dividend income is much greater for the undervalued stocks than for the overvalued stocks. Mirroring the difference in capital gains, the investment in the stock with an initial P/E of 11 gives off more than double the dividends in Year 25 compared with an investment in the stock with an initial P/E of 19. This is why valuation is relevant and important for dividend growth investing. Not only do undervalued stocks have the potential for greater capital gains, but they can also boost the dividend income stream.

## Long-Term Effects of Short-Term Valuation Differences

Even though John Maynard Keynes said that the market can remain irrational longer than you can remain solvent, one might raise the objection that stocks are unlikely to remain undervalued or overvalued for as long as I assumed in the preceding example. To address this concern, in this second example I made all the same assumptions except for one change. Instead of having the P/E ratios converge to 15 after 25 years, I made them converge after just 2 years. From Year 3 onward, all stocks had a P/E of 15. Figure 5 shows the year-end portfolio values:

The differences between the stocks are smaller than in Figure 3, but it is still the case that the initially undervalued stock investments end up being worth much more than the initially overvalued stock investments. For example, after 25 years the investment with an initial P/E of 11 is worth 74% more than the investment with an initial P/E of 19. Not surprisingly, a similar pattern holds for dividend income, as shown in Figure 6:

As before, the undervalued stock investments give off more dividend income than the overvalued stock investments. Remember that the period of under- or overvaluation lasted just 2 years for this example, yet it produced substantial long-term effects on dividend income. Moreover, these effects occurred in the context of modest levels of overvaluation: the "overvalued" stocks had P/E ratios below 20. Imagine how much larger the long-term differences in portfolio value and dividends would be if a stock was bought at a P/E of 25, 30, or higher.

## Conclusion

These examples demonstrate the importance of valuation for dividend growth investing. All other things being equal (initial investment, earnings, earnings growth rate, dividends, and dividend growth rate), the projections show that investing in undervalued stocks can potentially result in a portfolio value and dividend income that are much higher than what you might get from investing in overvalued stocks. Of course, actual stocks do not exhibit the fixed rates of earnings and dividend growth that I have assumed, and their prices often have considerable volatility, but I think the basic trends from the projections have some validity in the real world.

This is why valuation is a primary consideration when I make investing decisions for my own dividend growth stock portfolio, which I described in a previous article. I look for stocks that are either undervalued or fairly valued, and I will not buy stocks that are overvalued (though I may continue to hold stocks that become slightly overvalued due to price appreciation). For example, some of my purchases during the past year have included undervalued stocks such as Intel (NASDAQ:INTC) at a P/E of 8.5, Norfolk Southern (NYSE:NSC) at a P/E of 10.5, and Cummins (NYSE:CMI) at a P/E of 8.7. (Note that these were the P/E ratios when I bought the stocks.) For NSC and CMI, the market has already begun to reappraise the stocks to more appropriate valuations, resulting in large capital gains.

Following Warren Buffett's suggestion that "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price," I also buy fairly valued stocks of high-quality companies, with examples being Hormel Foods (NYSE:HRL) at a P/E of 16.0, V.F. Corporation (NYSE:VFC) at a P/E of 16.0, and Ross Stores (NASDAQ:ROST) at a P/E of 17.0. (Even though I characterized P/E ratios above 15 as "overvalued" in my projections, this was a simplification and does not apply to all stocks in the real world.) Of course, P/E is just one of many metrics I use when performing stock valuation, and I recommend that all investors conduct thorough due diligence before making investment decisions. If that due diligence includes consideration of valuation, then the investment outcome could be more than satisfactory with respect to both capital gains and dividends.

**Disclosure: **I am long CMI, CVX, HRL, INTC, JNJ, KO, MCD, NSC, ROST, VFC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.