I have been rather baffled by recent articles arguing for or against dividend stocks being in a bubble. Below is a long term chart of the NASDAQ and Vangaurd's Dividend Appreciation ETF, a reasonable proxy for dividend growth stocks. It is easy to see the parabolic price moves from the NASDAQ but no matter how hard I squint, I can't spot any bubble in dividend stocks.
Remembering what the term actually means, claiming that dividend paying blue chip stocks are in a bubble is downright silly. VIG is actually slightly below its all time high. However, an asset price doesn't have to be in a bubble to be overvalued. Given the relative outperformance of defensive sectors, and the fact that VIG has outperformed SPY over the last five years, it makes sense to stop and take a look at the valuation of dividend paying stocks and try to determine whether or not they are overvalued.
Like most dividend growth investors, I concentrate on individual stocks and care relatively little what "the market" is doing. For this article I selected four of the most commonly "DRIPped "stocks [McDonalds (NYSE:MCD), Coca Cola (NYSE:KO), Proctor & Gamble (NYSE:PG), Altria (NYSE:MO)] as well as a pipeline, a telecom and a utility [Enbridge (NYSE:ENB), Verizon (NYSE:VZ), Southern Co. (NYSE:SO)] to look at.
While simplistic, to me one of the purest methods of valuing a company is its earnings yield. If we assume that a company is a wise allocator of capital, it will invest back into itself the capital it can earn a high rate of return on and then distribute the rest via share buybacks or dividends. This also nicely avoids the tiring debate on dividends vs. non-dividend stocks, or buybacks vs. dividends.
I also like to look at a company's historical valuations; the equally simple idea being that if investors are paying much more per dollar of earnings now as compared to historically, assuming EPS growth is constant, there is a good chance the company is overvalued.
Analysts try to estimate what a company's EPS will be and then guess at what P/E multiple investors are willing to pay for those earnings to come up with a price target. While I tend to take these targets with a large grain of salt, I have chosen to include analyst's estimates in this analysis as they can account for such things as the effect low interest rates have on P/E valuations.
5 year Average Earnings Yield
% Above 5-yr Avg Earnings Yield
Proctor & Gamble
Analyst Price Target
% Upside (Downside) based on Price Target
Proctor & Gamble
With a P/E of 19 and a PEG of 1.82, it would be hard to argue that the fast food king is a cheap stock right now. On the other hand, McDonalds has rarely been cheap as investors pay a premium for this best-in-breed company that has delivered steady, impressive returns over the years. While I think the analyst target is a bit rich, I own shares of MCD right now and am happily holding them.
I find the market strange at times; case in point: the pounding McDonald's shares took today on sales growth that was slightly below expectations but still very impressive. If this dip continues another few percentage points, I will strongly consider adding to my holdings.
The Coca-Cola Company
Like McDonalds above, The Coca-Cola Company is trading at a robust P/E of 18.6. Despite facing headwinds from changing consumer preferences, Coca-Cola has been a model of efficiency that is projected to grow EPS by about 7% over the next five years. I believe shares of KO are fairly valued right now and will only track EPS growth. This still leads to a total return of 10% annualized over the next five years and investors could do a lot worse than that. Conservative minded investors should be fine investing in additional shares under $70 per share.
It may not be surprising in this world of zero percent interest but high yield stocks are looking a little pricey. Compared to historical valuations, shares of Verizion and Altria are overvalued by more than 30%. These are both quality companies but my concern for investors in these stocks is that when (NYSEMKT:IF) interest rates normalize in the coming years, P/E compression will lead to significant losses.
As long as we have ZIRP, stock prices for these companies should be supported by earnings growth - especially VErizion. It's not like we are going to wake up tomorrow and find the Fed has raised short term rates to 4%, so investors who need the current income should hold for now but be diligent about the future. Investors with a longer time frame may benefit from switching to higher growth but lower yield sectors over the next year or two.
Enbridge was the second stock I ever owned and my first DRIP stock, so I am more than a little attached to the company. I am also quite bullish on the company's future: much more pipeline capacity is needed in North America in general and in the Canadian oilsands in particular. The fact that this best-in-breed company is a large, mature pipeline operator and is still projected to grow EPS by over 10% the next five years is truly remarkable.
Having said all this, Enbridge hit an all time high in both price and valuation this year. A pipeline with a P/E kissing 30 and a PEG over 3.0 is bordering on the insane. I actually sold some shares of Enbridge last month, my first and only sell of this company in almost twenty years. I must admit part of the rationale was that Enbridge has grown to be a substantial part of my portfolio; if I had a smaller holding, I would have happily held.
I will leave it to the deep value investors to pick around in the rubble of distressed companies to look for cheap prices. For myself, I am happy to pick up good companies at good prices. Stable blue chips likes McDonalds and Coca-Cola are currently fully valued but their prices are in no way extreme. Investors could do a lot worse than holding these reliable stocks.
High yield names do look more than a little extended at this point. I excluded REITs and MLPs from this analysis as it would not be an "apples to apples" comparison; however, I believe these sectors are overvalued as well. Long term investors should be careful at how much they are paying for yield.