As a dividend growth investor, I place a high value on valuation (pun intended). There are several reasons for this, but two of the most important are:
- Better-valued stocks are less likely to deal you a capital gains disappointment over the long term.
- Better-valued stocks are likely to be offering a higher initial yield.
The capital gains margin of safety is important even in dividend growth investing. For one thing, you may be a dividend growth investor who focuses mainly on capital gains or total returns, as some do. Second, even if capital gains are not your major emphasis, they may be a secondary focus. (That describes me. All else equal, I would rather enjoy capital gains instead of experiencing capital losses over the long term.) Third, a margin of safety around capital gains could become important if some calamity strikes a stock, such as it cuts its dividend. If the calamity leads you to sell it, the more capital you can recover the better, as you will need to reinvest it to replace the income you lost in the calamity/sell-off.
The higher initial yield point is obvious. Yield and price are inversely related. Yield = Dividend / Price. As price goes down, yield goes up and vice-versa. So buying at a better valuation (lower price) means that you get a higher yield right out of the starting gate. Assuming that your stock never cuts its dividend, your initial yield is the lowest yield on cost that you will ever experience for that purchase. It's locked in. So obviously, all else equal, a higher initial yield is better.
Price vs. Valuation
In reading comments over the past few months, I have seen a bit of confusion between valuation and price. So let's take a few paragraphs to talk about the difference.
Price is the cost of a share. Price changes constantly. Since price and yield are inversely related, that means that yield changes constantly too.
A common concept in stock investing is intrinsic value. It is also known as fair value, actual value, true worth, correct value, proper value, etc. Let's look at a couple of definitions of intrinsic value. The first comes from Investopedia:
The actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value.
The second comes from Wikipedia:
[T]he actual value of a company or stock determined through fundamental analysis without reference to its market value. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value.
As you can see, the idea is to arrive at an objective assessment of a stock's inherent financial value today, regardless of what the stock is selling for on the open market. This may sound simple and precise, but actually there are a multitude of ways to calculate fair value.
That means that 50 different investors, all using reasonable techniques and all attempting to be unbiased and rigorous, could arrive at 50 different estimates of intrinsic value for a single stock. For that reason, I consider fair value calculations to lie in the realm of assessments. Reasonable minds can differ, and it is often prudent to get more than one opinion.
On the market at any given time, a share of stock sells for a certain price. One might think that the market price is the intrinsic value, with so many market participants doing their best to arrive at fair prices. In fact, the Efficient Market Hypothesis (EMH) postulates exactly that, as shown in this Investopedia definition:
An investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges…
However, many investors (including myself) believe that EMH is incorrect, because examples of market price "mistakes" can be found all of the time. Again from Investopedia:
For example, investors, such as Warren Buffett have consistently beaten the market over long periods of time, which by definition is impossible according to the EMH. Detractors of the EMH also point to events, such as the 1987 stock market crash when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day, as evidence that stock prices can seriously deviate from their fair values.
If you believe EMH, there is no point in reading further, because the rest of this article is going to talk about favorable prices at which to purchase dividend growth stocks. If you believe EMH, any and every market price is a good price, because you cannot do better. If that is true, there is no such thing as an undervalued or overvalued stock, since prices are always correct.
If you are still reading, it should by now be apparent that price and valuation are different. What makes a price "better"? Speaking from the point of view of a buyer, a better price means being lower than intrinsic value. If you can purchase a stock at less than its intrinsic value, you are tilting the odds in your favor that future price movements will be favorable to you. This is widely known as margin of safety. The wider the price gap in your favor, the larger your margin of safety.
While obviously if a price is lower than it was last week, it is "better" (for a buyer) than it was last week, that does not mean that it is a good price in the sense of being lower than intrinsic value. I think this is the source of confusion between price and valuation. People see a price drop, and they think that makes a stock a good buy. "Buy on dips." But that's not necessarily true. The lowered price may still be above fair value.
Here is an example: Wisconsin Energy (NYSE:WEC). WEC is a fairly popular dividend growth stock. Notice the significant recent price dip on this chart from Morningstar:
An investor looking at that chart - which shows price only - might think that the price drop of about 6% in 18 days presents a great buying opportunity.
I wouldn't agree. Let's look at F.A.S.T. Graphs for the same stock:
F.A.S.T. Graphs place prices in context by showing comparisons to fair value. F.A.S.T. Graphs use "earnings justified valuations" to assess intrinsic value. That is shown by the orange line. We can see that the black actual price line is about 12% above that, even taking into account the recent price drop. That suggests that there is no margin of safety in WEC right now, in fact it is overvalued at this time. Its history shows that its price returns frequently to fair valuation, meaning that it is not perpetually overvalued, as some stocks are. So there seems to be no reason to pay an overvalued price for it.
Morningstar assesses WEC's fair value as $35.00 (premium content), so its current price of almost $41 is about 16% higher than that. Morningstar rates WEC as a 2-star stock on a 5-star scale, so the stock is overvalued by their reckoning too. F.A.S.T. Graphs and Morningstar are the two sources that I primarily use to assess valuation. So I wouldn't purchase WEC here despite the recent price drop.
Here is more support for that view. One of my favorite tools on F.A.S.T. Graphs is the forward-looking Estimated Earnings and Returns Calculator. This projects the orange fair-value line forward using earnings estimates from Capital IQ (Standard & Poor's). One thing I like to do is scan horizontally from the current price (the end of the black line) to see where it intersects the projected orange line.
If you scan horizontally here, you can see that WEC's current price, if it stayed flat, would intersect the orange fair-value line around the end of 2015. That suggests that WEC's price is more than two years "ahead of itself." The odds are not tilted in your favor for future price increases, in fact they are tilted against you.
Should You Pay Up for Quality?
Another topic that has been discussed recently is "quality." The idea is that if you have a truly high-quality company, you should be willing to "pay up" for it: Pay full fair value, even more, because 10-20 years from now, you won't care that you paid a buck or two more for the shares. They will have appreciated, and you will have cashed in on all those years of dividend growth too.
I generally agree with this. However, "quality" is such an amorphous concept that I suspect that it has an even wider dispersion of assessments than intrinsic value. Here are a few of the factors that I have seen mentioned in connection with how to assess quality:
- Whether the stock is a "blue chip" stock
- Credit ratings
- Value Line's ratings
- Length of dividend increase streak
- Lack of or low debt
- Recent earnings history and trends
I'm sure there are others. For myself, I measure "quality" according to a grading system that I have developed over many years. The way that I do it, I end up assessing some stocks as high quality that would be on no one's list of blue-chip stocks. Others would be on practically everyone's list.
But I will pay full value for many of these stocks. It is not totally a rules-based decision. It is more like a verdict, taking into account lots of evidence. In addition to the grading system, I consider such things as the fit of the stock in my portfolio, its current yield, its recent dividend growth rate, and other factors that are peculiar to my situation rather than being universal in nature. That means that there is some subjectivity to these decisions.
Thus far, I have never paid what I consider to be an overvalued price for any stock. When I have money to invest - such as from accumulated dividends - I value every stock on my watch list. I use a 10-point scale, with 10 being most undervalued and 1 being most overvalued. Then I eliminate every stock with a score of 4 or below. It does not matter how much I "want" the stock. The last time I did this, a few weeks ago, that step eliminated 10 of 40 stocks. If I had set the cutoff at 5 or below, 17 of 40 would have been eliminated.
I prefer to buy something at a valuation of 7-10, but as I said earlier, I will "pay up" (i.e. buy a stock rated 5-6) if other factors fall into place. My last purchase, in fact, was a 6: Phillip Morris (NYSE:PM). Here's how its FASTgraph looked:
I consider anything in the two narrow bands above and below the orange line to be fairly valued, and I assign 3 points (out of a possible 5) for that. Morningstar had PM rated 3 stars, which was another 3 points. Adding the two together, I got a valuation of 6, which is fully valued. I liked other aspects of the company, especially the international focus of its business. It was a good fit for me, so I bought it. Long-term, I think I got a good deal.
Disclosure: I am long PM. 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.