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The dividend growth model for valuing a stock is based upon the premise that the value of the stock is the present value of the future dividends. Stocks with consistent dividend growth, lower business model risk, and low valuations should be positioned for price gains and good cash returns.

Dividend Growth Model

The dividend formula is Current Price = End of Year Dividend / (Required Equity Return – Growth). A more detailed explanation is available here and here. It is also called the dividend discount model and the Gordon growth model. The Required Equity Return can be calculated using the Capital Asset Pricing Model:

Equity Return = Risk Free Rate + Beta x Equity Risk Premium

In 2010, CXO Advisory estimated the Equity Risk Premium for U.S. stocks at 5.1%. I’ve seen other estimates go as high as 7%. The Risk Free Rate is most typically associated with the U.S. Treasury bond with the most appropriate time frame to match that of stocks. In this case, I would use the 10-year bond, which is probably still too short of a time frame for stocks. The 10 year bond is currently yielding 3.65% and I used 6% for the equity risk premium.

Some rearrangement of the formula gives: Equity Return – Growth = Dividend/Price = Dividend Yield. So the best stocks are the ones with high Dividend Yields relative to Equity Return – Growth, so the goal is to maximize: Yield – Return + Growth.

It should be noted that accurate analysis, the Yield used above, should be based upon the expected dividend to be received in one year's time. For simplicity, I will just use the current Yield.

Analysis

I ran a stock screen that looked for low beta stocks (which corresponds to low equity returns) and high dividend yields. The Yahoo!Finance screener came up with 87 stocks that met the criteria Enterprise Value/Free Cash Flow < 10 and Dividend Yield > 1%. I also required a minimum market capitalization of $1 billion and positive earnings per share both this year and next year. I set the yield criteria relatively low to capture a large sampling of potential investment opportunities. The point of the valuation metric was to find stocks that had potential to appreciate in value, in addition to providing good dividends. The following tables show the rankings of the top 20 stocks by the maximizing the formula Yield - Return + Growth.

Table1: Top Stocks by Yield + Growth - Return
Ticker Company Name Beta Return Yield Growth Yield + Growth - Return
(WOR)
Worthington Industries Inc. 1.4 11.8% 2.8% 31.5% 22.6%
(ENH) Endurance Specialty Holdings Ltd 0.7 8.1% 2.7% 24.1% 18.7%
(SUN)
Sunoco Inc. 0.4 6.3% 1.7% 18.1% 13.5%
(ANF)
Abercrombie & Fitch Co. 1.7 13.7% 1.9% 21.7% 9.9%
(CCU)
Compania Cervecerias Unidas SA 0.5 6.8% 3.0% 13.7% 9.9%
(LEG)
Leggett & Platt Inc. 1.3 11.6% 5.5% 15.0% 8.9%
(FNF)
Fidelity National Financial Inc. 0.7 7.6% 4.9% 11.5% 8.8%
(ISIL)
Intersil Corp. 1.2 11.1% 4.5% 15.0% 8.4%
(XOM)
Exxon Mobil Corp. 0.4 6.1% 2.9% 11.1% 7.9%
(CINF)
Cincinnati Financial Corp. 0.8 8.3% 5.9% 10.0% 7.6%
(AXS)
Axis Capital Holdings Ltd. 0.7 8.0% 2.7% 12.8% 7.5%
(BWP)
Boardwalk Pipeline Partners LP 0.1 4.4% 6.6% 5.0% 7.2%
(RAI)
Reynolds American Inc. 0.7 7.7% 6.5% 7.8% 6.5%
(MO)
Altria Group 0.5 6.4% 6.2% 6.5% 6.2%
(RLI)
RLI Corporation 0.4 6.1% 2.2% 10.0% 6.1%
(WM)
Waste Management, Inc. 0.6 7.2% 3.7% 9.6% 6.1%
(TWX)
Time Warner Inc. 1.3 11.2% 2.8% 14.2% 5.8%
(CB)
Chubb Corporation 0.5 6.4% 2.7% 9.3% 5.7%
(WRB)
W.R. Berkley Corp 0.4 5.8% 1.1% 10.0% 5.4%
(LINE)
Linn Energy LLC 0.7 7.9% 8.7% 4.0% 4.9%

Data sourced from Yahoo!Financial on February 6, 2011

However, there is a potential trade off between valuation and the dividend maximization. The following table shows the ranking of companies with the Yield + Growth - Return above 5% ranked by Enterprise Value/Free Cash Flow.

Table 2: Top stocks ranked by EV/FCF
Ticker Company Name Enterprise Value/ Free Cash Flow Forward P/E Yield + Growth - Return
AXS Axis Capital Holdings Ltd. 2.7x 8.4x 7.5%
CCU Compania Cervecerias Unidas SA 2.8x 15.1x 9.9%
WRB W.R. Berkley Corp 3.1x 11.2x 5.4%
WM Waste Management, Inc. 3.6x 16.6x 6.1%
ENH Endurance Specialty Holdings Ltd 4.4x 9.0x 18.7%
SUN Sunoco Inc. 6.1x 18.8x 13.5%
CB Chubb Corporation 6.1x 10.1x 5.7%
MO Altria Group 6.7x 10.8x 6.2%
RAI Reynolds American Inc. 8.0x 12.2x 6.5%
ISIL Intersil Corp. 8.4x 17.8x 8.4%
LEG Leggett & Platt Inc. 8.4x 12.8x 8.9%
RLI RLI Corporation 8.4x 14.0x 6.1%
ANF Abercrombie & Fitch Co. 9.1x 17.6x 9.9%
WOR Worthington Industries Inc. 9.4x 12.4x 22.6%
CINF Cincinnati Financial Corp. 9.5x 23.1x 7.6%
TWX Time Warner Inc. 9.6x 13.4x 5.8%
XOM Exxon Mobil Corp. 10.0x 10.4x 7.9%

Data sourced from Yahoo!Financial on February 6, 2011

Note that Boardwalk Pipeline and Fidelity National dropped out due to negative Free Cash Flow.

Additional Analysis to Refine the List

While this method provides a good starting point for additional fundamental analysis, there are several areas that would require additional analysis. The rankings were highly influenced by the growth factor.

I looked at the growth component 3 ways:

  1. 5 year historical earnings growth (reduced to 26 companies for above 1% growth)

  2. 5 year forecasted earnings growth (reduced to 81 companies for above 1% growth)

  3. Next year’s EPS vs. current year’s EPS

Ultimately, the forward projected growth is probably the most useful; however, there were several large companies that showed projected earnings growth much higher than historical growth. While this is not necessarily an issue, it should warrant additional analysis as to why there is higher future growth projected. Table 3 highlights a few of these.

Table 3: Change in Growth
Ticker Company Name 5 Year Historical 5 Year Projected Growth Change
WM Waste Management, Inc. 3.2% 9.6% 6.4%
CB Chubb Corporation 7.5% 9.3% 1.8%
RAI Reynolds American Inc. 4.4% 7.8% 3.3%
RLI RLI Corporation 6.7% 10.0% 3.3%

Data sourced from Yahoo!Financial on February 6, 2011

Additional metrics such as P/E ratios, return on assets and return on equity could be used to further narrow the list. For example, Abercrombie & Fitch, Intersil, Sunoco, and Cincinnati Financial all had forward P/Es over 15x. While a high growth rate could compensate for that, Cincinnati Financial had only a 10% projected earnings growth suggesting it was already full valued.

The other key issue is Beta which has some issues with it since it is calculated based on the covariance between the stock returns and the market returns. It is significantly influenced by time frame over which it is calculated.

Conclusion
These stocks represent interesting potential investment opportunities. The names range from the very familiar, Exxon Mobil, to the less familar, Compania Cervecerias Unidas SA, a beverage company operating in Chile and Argentina. As with any investment opportunity, additional analysis and research would be necessary.

Source: 17 Dividend Stocks Poised for High Cash Returns