A Unique Method To Value Dividend Stocks Based On Expected Growth

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Includes: AAIDY, AAPL, ABT, ADM, APD, BASFY, BAYZF, BDX, CL, DEO, DIS, EMR, FSNUY, GE, GILD, GSK, HENKY, HON, HSY, IBM, JNJ, KHC, KO, MA, MDLZ, MKC, MMM, MURGY, PEP, PG, PX, RBWNY, SBUX, SIEGY, UN, UTX, V
by: Gold Finder

Summary

For the long term, growth in earnings per share is required for dividend growth.

Growth stocks and overvalued Aristocrats are too risky for DG investors.

With the formula of Graham, such stocks can be filtered out to help the investor with scanning the personal watch list.

There are multiple popular fields of investing in common stock, such as "value investing", "growth investing" and "dividend growth investing". Especially the latter is very interesting and favored here on Seeking Alpha. For four years now, I have been investing in the stock market - I started with my first real investment when I was 17 years old. The last two years, I have been increasingly more fascinated by the phenomenon of dividend growth investing.

What is so tempting about this type of investing? Well, it seems to be a safe and sound strategy to generate a lifetime growing cash flow. Unlike capital appreciation (or depreciation), a dividend feels more solid, more real. Especially a growing, solid and real dividend truly sounds pretty good (and maybe also just is good).

In order to construct a dividend growth portfolio, some kind of valuation method is required. As we speak, the S&P 500 trades at a P/E ratio of 24x earnings. This is above the historical average and median of ~15 times this metric. Therefore, many analysts and investors consider the current stock market as overvalued. To confirm this statement, Benjamin Graham, the author of "Security Analysis" and "The Intelligent Investor", claims that an investor should never pay more than 15x earnings.

This valuation metric would rule out most Dividend Aristocrats and other high-quality holdings; therefore I shall discuss another valuation method to build a dividend growth portfolio.

My principle for DG stocks

Essentially, one of the most important formulae for DG stocks is: EPS/dividend = Payout ratio. The lower the payout ratio, the safer the dividend generally is and the more it has room to grow. Dividend growth can exceed EPS growth in the short term. However, for the long term, a growing EPS is needed for continued dividend growth.

To prove my point that EPS should outgrow dividend growth, I shall use the example of Procter & Gamble (NYSE:PG).

PG Payout Ratio (<a href=

PG Payout Ratio (TTM) data by YCharts

The company's payout ratio increased the last decade, therefore making future dividend raises limited. In fact, PG's last dividend raise was only 1%.

Main thesis

Earnings growth is important, and growing earnings per share are needed to support long-term dividend growth. How much growth is actually needed? How much is already priced in? Is a double-digit growth company superior to a single-digit growth company for DGI? When do you overpay for growth? This are important questions that need to be answered before any purchase is made.

Let's take a look at some growth stocks and their valuations.

Visa (NYSE:V) and Starbucks (NASDAQ:SBUX) have a P/E ratio which is higher than 15x earnings. Benjamin Graham suggests never to pay more than 25x the average EPS of the last five years. Earnings can be volatile, and high earnings growth is nearly never sustainable. Consequently, an average of the EPS with a maximum of 25 times this number is needed to protect the investor against high losses when the predicted growth rates are not realized.

When this method is applied to the companies named above, the following results are obtained:

Starbucks

Earnings year EPS
2011 $0.81 Average
2012 $0.90 $1.204
2013 $1.13
2014 $1.36
2015 $1.82
Visa Earnings year EPS
2011 $1.29 Average
2012 $0.79 $1.744
2013 $1.90
2014 $2.16
2015 $2.58
Click to enlarge

For both companies, the limit of 25x average earnings is exceeded: 45x and 47x. Of course, this method can be questioned based on the fact that the 2011 earnings are much lower than the 2015 earnings for Starbucks and Visa. Especially when the forward P/E ratio is taken into account, the numbers are much lower: 29x and 33x. Still, this method shows us that when Visa or Starbucks would stop growing or even start to decline, annualized returns will be decimated. History has shown us that not many companies manage to keep growing at a strong pace, and also that some companies which were expected to grow actually started to decline (look at the many tech stocks of the last century with "excellent growth prospects" that went bankrupt).

To back up my claim that paying too much for a growth stock can result in low returns, I shall introduce theoretical Company "A".

Company "A" earns $1 per year and is expected to grow earnings at 12% per annum for the next 10 years. This results in EPS of $3.11 in 2026. If those earnings will be valued at an multiple of 15x earnings (the S&P 500's past medium/average) the stock itself will be valued at $46.59 in 2026. A possible outcome is that the growth was still spectacular (10%), but lower than the previously stated 12%. EPS in this 10% scenario is only $2.59 at the end of 2026. If the same multiple of 15x is used, then a value of $38.91 is obtained - this would be 16.5% lower than when growth would have been 12%.

Company "A" 10-year annual growth EPS 2026 Stock price 2026 (15x EPS)
12% $3.11 $46.59
11% $2.84 $42.59
10% $2.59 $38.91
9% $2.37 $35.51
8% $2.16 $32.38
7% $1.97 $29.51
6% $1.79 $26.86
5% $1.63 $24.43
4% $1.48 $22.20
3% $1.34 $20.16
2% $1.22 $18.28
1% $1.10 $16.57
0% $1.00 $15.00
-5% $0.60 $8.98
Click to enlarge

Actually, when a spectrum is considered with an annual growth of -5% up until 12% for the next decade, the stock price can be as low as $8.98 and as high as $46.59.

Now let's assume that Company "A" has been growing its earnings in the last five years at a rate of 12% in order to arrive at an EPS of $1. The average EPS multiplied by 25 results in a value of $19.19:

Company "A" EPS Year
$0.57 -5
$0.64 -4
$0.71 -3
$0.80 -2
$0.89 -1
$1.00 0
Average EPS $0.77
Valuation (25x average EPS) $19.19
Click to enlarge

We have now some numbers on which we can make conclusions about Company "A". The stock would now be worth $19.19 (based on the valuation metrics used) and can be worth as much as $8.98 to $46.59, depending on the growth rates stated above. In the optimal situation of continued growth at 12%, an annualized return of 9.2% will be seen. If growth declined to 8%, the company will realize an annualized return of 5.4%.

Still, these are optimistic scenarios, and annualized returns range from 5.4-9.2%, rather low for the risk taken.

Now let's look at an example where another valuation method is followed: we will pay 25X current earnings for Company "A". The company is now valued at $25 a share. The expected returns will now be decimated: in an 8% growth scenario to a 2.6% annualized return, and in the 12% scenario to 6.4%.

Annualized return of 1.7% is achieved in the 7% growth scenario. Below the 6% growth scenarios, the stock will be doomed for negative returns. It gets even worse when Company "A" is valued above 25x current earnings.

Does this affect my growth holdings?

Of course, this example is pure theoretical, but it illustrates the risks and effects on future EPS when expected growth is not realized.

To ask yourself if your holdings could also suffer a risk like Company "A", the following should be considered:

The higher the expected growth is by the general market, the higher the stock's price will be. This implies that when the growth rate will not be achieved, the stock has more room to fall than one that was not expected to grow a lot. In other words, the risk will increase when the expected growth rate is high.

My valuation approach

Since I just showed that differences in earnings growth can greatly influence future stock prices, it is essential to know what kind of growth is needed to justify the purchase price of stocks. Graham provides us a useful formula to calculate the value of a common stock based on its stock price, earnings and expected growth:

Value = Current earnings * (8.5 + 2*growth%)

This formula is easy to understand. A zero growth stock is normally valued at 8.5 times earnings (an example of this is Gilead (NASDAQ:GILD)). Next, the growth is added to this number of 8.5. The result of this formula is the "value". If a stock is purchased above its value, a bad return is likely. If a stock is purchased at value but growth turns out to be lower than expected, a bad return is likely.

For Company "A", it can be calculated that the shares would be fully valued at $32.50 - i.e., 1 * (8.5 +12) = 32.50. But if growth ends up being 4 percent points lower than expected, virtually no returns are achieved in the next 10 years. This proves the usefulness of the formula. At value ($32.50) or higher, the margin of safety is rather low when growth is lower than expected.

The formula just mentioned can be rewritten as:

Growth% = Value/(2 *earnings) - 8.5/2

This formula is essentially the same, but the approach is now quite different. For "value", I shall use the current stock price, and for "earnings" the current earnings. This results in the calculation of "minimal needed growth" (MNG) to support the current stock price.

Why is this "minimal needed growth"? It is quite simple. The market expects a "x" amount of growth when it assigns a specific price to a common stock. When this growth is not achieved, the stock has traded too high. Therefore, this calculated growth is minimally needed. If growth is actually higher than implied by the price paid, higher returns will be realized.

It also makes quite a lot of sense. Take a look at Apple (NASDAQ:AAPL):

AAPL Chart

AAPL data by YCharts

In 2013, Apple hit lows below $70. EPS had fallen, which resulted in a lower stock price. Growth was expected to be low or even negative, which resulted in lower "value" of the stock. As the graph shows, growth returned and EPS actually excelled. Result? The value (according to the formula) exploded, and so did the stock. In 2016, growth is questioned once more, resulting in a depressed stock price. The formula describes exactly this behavior.

Via websites such as Reuters, the long-term growth rates of nearly all companies can be found. When the MNG is lower than the LT growth rate, the stock is safer for purchase. Why? If the market prices a stock at a growth rate of 5% for its earnings, while the last year's earnings grew by 10%, there is some kind of a margin of safety.

Ideally, stocks with a low MNG (below 10%) and a big gap between MNG and past long-term growth are safer for purchase. MNG below 10% is desirable, as stated above, since companies in the past generally failed to see continued double-digit results, and will therefore have an increased risk of wild fluctuations in future stock prices (see the example of Company "A").

A list of several stocks

I have put this formula to work on a list of some stocks which I consider interesting because of a "moat" or because of their Aristocrat status. The following results are obtained:

Company Price Earnings MNG % Actual growth % Discounted growth % Dividend
Muenchener Rueckver AG (OTCPK:MURGY) € 160.65 € 18.70 0.05 -5.06 -4.55 5.24%
GlaxoSmithKline PLC (NYSE:GSK) £ 1,616.00 £ 76.50 6.31 13.64 12.28 4.96%
BASF SE (OTCQX:BASFY) € 70.30 € 4.33 3.87 3.05 2.75 4.22%
Boskalis (OTC:RBWNY) € 30.90 € 3.54 0.11 1.70 1.53 4.90%
Siemens AG (OTCPK:SIEGY) € 103.75 € 6.50 3.73 7.97 7.17 3.51%
Abbott Laboratories Inc. (NYSE:ABT) $ 41.87 $ 1.80 7.38 9.36 8.42 2.48%
Emerson Electric Co. (NYSE:EMR) $ 51.09 $ 3.00 4.27 7.05 6.35 3.73%
Procter & Gamble Co. $ 88.05 $ 4.00 6.76 6.77 6.09 3.10%
Unilever Cert. (NYSE:UN) € 40.22 € 1.80 6.92 5.64 5.08 3.17%
Archer Daniels Midland (NYSE:ADM) $ 42.03 $ 2.70 3.53 8.75 7.88 2.86%
General Electric Co. (NYSE:GE) $ 29.68 $ 1.50 5.64 12.48 11.23 3.17%
Coca-Cola Company (NYSE:KO) $ 42.14 $ 1.80 7.46 3.00 2.70 3.29%
Diageo PLC (NYSE:DEO) £ 2,121.00 £ 90.00 7.53 8.47 7.62 2.97%
PepsiCo Inc. (NYSE:PEP) $ 105.28 $ 4.30 7.99 7.10 6.39 2.77%
Kraft Heinz Company (NASDAQ:KHC) $ 88.94 $ 3.00 10.57 23.51 21.16 2.56%
Praxair Inc. (NYSE:PX) $ 117.68 $ 5.65 6.16 6.14 5.53 2.47%
3M Co. (NYSE:MMM) $ 175.00 $ 7.60 7.26 8.93 8.04 2.53%
United Technologies Corp. (NYSE:UTX) $ 100.00 $ 6.50 3.44 8.24 7.42 2.60%
Johnson & Johnson Inc. (NYSE:JNJ) $ 118.00 $ 5.70 6.10 6.57 5.91 2.65%
Bayer AG (OTCPK:BAYZF) € 90.78 € 5.64 3.80 7.65 6.89 2.94%
Hershey Foods Corp. (NYSE:HSY) $ 95.48 $ 3.70 8.65 7.97 7.17 2.52%
Air Products & Chemicals Inc. (NYSE:APD) $ 145.80 $ 5.88 8.15 10.02 9.02 2.26%
Gilead Sciences Inc. $ 78.80 $ 10.00 -0.31 -0.21 -0.19 2.35%
Colgate-Palmolive Co. (NYSE:CL) $ 71.96 $ 2.40 10.74 7.47 6.72 2.17%
Honeywell International Inc. (NYSE:HON) $ 114.26 $ 6.04 5.21 9.67 8.70 2.13%
Aalberts Industries (OTC:AAIDY) € 29.43 € 1.50 5.56 8.40 7.56 1.94%
Becton, Dickinson (NYSE:BDX) $ 175.20 $ 6.00 10.35 12.69 11.42 1.50%
Walt Disney Co. (NYSE:DIS) $ 92.56 $ 4.90 5.19 10.74 9.67 1.53%
Henkel AG & Co. KGaA (OTCPK:HENKY) € 102.15 € 5.00 5.97 7.33 6.60 1.65%
Fresenius SE & Co. KGaA (OTCQX:FSNUY) € 69.16 € 2.53 9.42 11.14 10.03 0.90%
MasterCard (NYSE:MA) $ 99.36 $ 3.35 10.58 15.25 13.73 0.74%
Starbucks $ 53.74 $ 1.82 10.51 18.84 16.96 1.51%
McCormick & Co. (NYSE:MKC) $ 95.86 $ 3.11 11.16 8.87 7.98 1.79%
Visa $ 82.07 $ 2.58 11.66 16.07 14.46 0.68%
IBM Corp. (NYSE:IBM) $ 153.84 $ 12.00 2.16 2.85 2.57 3.40%
Click to enlarge

One interesting observation is about the company Gilead, which only needs to grow earnings at - 0.31% to be fully valued. A "zero growth example", as mentioned earlier.

The table below shows all companies which have MNG lower than 10% and a positive gap with the discounted growth (past growth discounted by 10%):

Company Discounted growth - MNG Dividend yield
GlaxoSmithKline PLC 5.96 4.96%
General Electric Co. 5.59 3.17%
Walt Disney Co. 4.47 1.53%
Archer Daniels Midland 4.34 2.86%
United Technologies Corp. 3.97 2.60%
Honeywell International Inc. 3.49 2.13%
Siemens AG 3.44 3.51%
Bayer AG 3.09 2.94%
Emerson Electric Co. 2.08 3.73%
Aalberts Industries 2.00 1.94%
Boskalis 1.42 4.90%
Abbott Laboratories Inc. 1.04 2.48%
Air Products & Chemicals Inc. 0.87 2.26%
3M Co. 0.77 2.53%
Henkel AG & Co. KGaA 0.63 1.65%
Fresenius SE & Co KGaA 0.61 0.90%
IBM Corp. 0.41 3.40%
Gilead Sciences Inc. 0.12 2.35%
Diageo PLC 0.09 2.97%
Click to enlarge

According to the formula used, all companies on this list have MNG lower than 10% and a discount to past long-term growth.

I own several companies named in the table, but also one company that did not pass the test: BASF. Of my German stocks, BASF underperformed, indicating that this method is indeed useful.

Other stocks such as Johnson & Johnson and Hershey also failed to pass the test. Hershey rose strongly in stock price after Mondelēz International, Inc. (NASDAQ:MDLZ) tried to buy the company out. Since the stock has not fallen back (yet) to levels seen before the attempt, the stock can be considered overvalued and my model confirms this.

JNJ Chart

JNJ data by YCharts

Johnson & Johnson stock price recently rose above its EPS, which is an indication that the stock is overvalued. My model also indicated this.

Conclusions

  • EPS growth is needed for continued long-term dividend growth.
  • The higher expected growth (minimal needed growth) is, the more risky the stock becomes. When this expected growth exceeds 10%, I consider the stock risky. Moreover, I have explained why high-growth stocks should be filtered out. The associated risk that comes with such purchases is too high for a DG investor.
  • This final list is not a recommendation, but the method used shows that all high-growth stocks were mathematically filtered out, as well as other equity that trades at a higher expected growth than realized in the past.

Disclosure: I am/we are long BAYZF, BASFY, GSK, EMR, GE, ABT, SIEGY, GILD.

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.

Additional disclosure: All earnings and past earnings growth are extracted from 4-traders.com and reuters.com

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.