It goes without saying that young investors like myself can afford to invest more aggressively than individuals closer to retirement. Our friends in their 50s and 60s might be more comfortable investing in extremely defensive positions in well-established companies that are going to turn a profit no matter what the macroeconomic conditions might be, while collecting a stable dividend four times a year. There is certainly nothing wrong with that investment strategy for investors of any age.
Folks in their 20s and 30s, however, might be looking for something more out of their investments. Don't get me wrong - dividends are important and should be a factor for anyone deciding where to put his or her money. But rather than focusing solely on yield, young investors should look at dividend growth and payout ratio.
Company A, which pays a 5 percent yield, might seem attractive at first glance. But if that company pays out 80+ percent of its profits in dividends, the yield might not be sustainable in a downturn, and not much is left over for the company to make investments to grow future earnings.
Instead, young investors might consider Company B, which yields 2.5 percent, with a payout ratio of 25 percent. This company has enough income leftover after dividends are paid out to support future earnings and dividend growth. And, should earnings slip for whatever reason, this company is far less likely to take money out of the pockets of its shareholders to keep the bills paid.
Another factor younger investors should consider is valuation. Stocks in the portfolios of retirees and those nearing retirement are likely those of mature companies with lower earnings growth. Again, I am not saying these are bad companies or bad stocks; indeed, this category includes some of the best-run and most respected corporations in the world. They are generally safe, defensive plays that would do well in any portfolio.
Undervalued stocks represent an opportunity for young investors to grow capital while collecting dividends at the same time. There are several methods of determining value, none of which should be the sole factor in evaluating which stocks to buy. One of these is the Graham number, which measures value based on EPS and book value. Other factors include price-to-book ratio and price-to-earnings ratio.
In the current market, with many stocks at or near all-time highs, finding solid undervalued stocks with sustainable dividends might seem like a gargantuan task. But there are some out there. I will highlight a few, looking at dividend growth and payout ratio to illustrate that these companies leave room for future growth in dividends and earnings. I will also utilize the Graham number to evaluate a "fair price" for these companies, as well as the value based on price-to-book ratio.
AFLAC Inc. (NYSE:AFL) is a supplemental health and life insurance company which operates in the United States and as a branch in Japan. The company offers various voluntary supplemental insurance products through sales associates and brokers, independent corporate agencies, individual agencies, and affiliated corporate agencies. Aflac Incorporated was founded in 1955 and is headquartered in Columbus, Georgia.
AFLAC currently pays a 2.80 percent yield, with a payout ratio of only 22 percent. Over the past five years, it has grown its dividend by 45.8 percent. At its current share price of $50.18, the P/E ratio is a very modest 8.22, with a similarly modest 1.46 price/book ratio. The "fair price," according to the Graham equation, is $79.49, which represents 58.4 percent upside based on current valuation.
The Allstate Corporation (NYSE:ALL) engages in the provision of personal property and casualty insurance, life insurance, and retirement and investment products primarily in the United States. The company markets its products through its agencies and financial specialists, independent agents and independent master brokerage agencies, and specialized structured settlement brokers, as well as directly through call centers and the Internet. The company was founded in 1931 and is based in Northbrook, Illinois.
Allstate pays a 2.01 percent dividend with a very low 19 percent payout ratio. The company, like many others, cut its dividend in the midst of the financial crisis; but has increased its payout by 25 percent since the initial cut in the first quarter of 2009. At the current share price of $49.73, the P/E ratio is 10.65, with a very attractive 1.16 price/book ratio. The Graham "fair price" is $67.19, which represents a 35.1 percent upside from current value.
National-Oilwell Varco, Inc. (NYSE:NOV) provides equipment and components for oil and gas drilling and production; oilfield services; and supply chain integration services to the upstream oil and gas industry worldwide. The Company operates through three segments. Its Rig Technology segment designs, manufactures, sells and services complete systems for the drilling, completion, and servicing of oil and gas wells. Its Petroleum Services & Supplies segment provides a variety of consumable goods and services used to drill, complete, remediate and workover oil and gas wells and service drill pipe, tubing, casing, flowlines and other oilfield tubular goods. Its Distribution & Transmission segment provides maintenance, repair and operating supplies and spare parts to drill site and production locations worldwide. The company was founded in 1862 and is headquartered in Houston, Texas.
NOV pays a low dividend yield of 0.75 percent, with a payout ratio of 8 percent. The company started paying dividends in the first quarter of 2010, and has increased payout by 30 percent since then. At the current share price of $69.31, the P/E is 11.86, with a price/book ratio of 1.44. The Graham "fair price" is $78.86, which represents a 13.8 percent upside based on current valuation.
Chevron Corporation (NYSE:CVX) engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. Upstream operations consist primarily of exploring for, developing and producing crude oil and natural gas; processing, liquefaction, transportation and regasification associated with liquefied natural gas; transporting crude oil by international oil export pipelines; transporting, storage and marketing of natural gas; and a gas-to-liquids project. Downstream operations consist primarily of refining crude oil into petroleum products; marketing of crude oil and refined products; transporting crude oil by pipeline, motor equipment and rail car, and manufacturing and marketing of commodity petrochemicals, plastics for industrial uses and fuel and lubricant additives. Chevron Corporation was founded in 1879 and is headquartered in San Ramon, California.
CVX pays a nice 3.01 percent yield, with a payout ratio of 26 percent. Over the past five years, the company has increased its payout by 38.5 percent. At the current share price of $119.32, the P/E is 8.98, with a price/book ratio of 1.69. The Graham "fair price" is $144.98, which represents a 21.5 percent upside over the current price.
PNC Financial Services (NYSE:PNC) is a financial service company. The Company has businesses engaged in retail banking, corporate and institutional banking, asset management, and residential mortgage banking. The company operates a network of 2,881 branches and 7,282 ATMs in Washington, D.C., as well as in 17 states. The PNC Financial Services Group, Inc. was founded in 1922 and is headquartered in Pittsburgh, Pennsylvania.
PNC pays a 2.62 percent yield, with a payout ratio of 29 percent. During the financial crisis, the company cut its dividend in the second quarter of 2009, but has increased payout by 400 percent since then. At its current share price of $67.19, the P/E is 12.63, with a price/book ratio of 0.99. The Graham "fair price" is $89.60, which represents a 33.4 percent upside over current valuation.
Kohl's Corporation (NYSE:KSS) operates family-oriented department stores that sell apparel, footwear and accessories for women, men and children; soft home products, such as sheets and pillows, and housewares. Kohl's apparel and home fashions appeal to classic, modern classic and contemporary customers. As of February 2, 2013, it operated 1,146 stores in 49 states. The company also provides online shopping through its Website Kohls.com. Kohls Corporation was founded in 1962 and is headquartered in Menomonee Falls, Wisconsin.
Kohl's pays a 2.93 percent yield, with a payout ratio of 31 percent. The company began paying a dividend in the first quarter of 2011, and has raised its payout by 40 percent since then. At its current share price of $47.86, the P/E is 11.37, with a price/book ratio of 1.74. The Graham "fair price" is $50.80, which represents a 6.1 percent upside over current share price.
Conclusion: While there is no magic number to determine which stocks best fit in any individual's portfolio, there are many different factors to help investors make educated decisions. Younger investors should look beyond dividend yield when choosing stocks for their retirement portfolios. Dividend growth and payout ratio, as well as where the stock stands with regards to valuation should be taken into account, as well. Capital appreciation from undervalued stocks, along with share appreciation from reinvesting dividends will mean that today's young investors will have plenty of money to buy income stocks when they're ready to retire.
Disclosure: I am long NOV. 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.