To state the obvious, in this low-interest environment, many investors are substituting dividend paying stocks for bonds. Focusing on high-yielding stocks, investors seek an alternative stream of income. Other investors focus on a company's ability to grow dividends over time. Our interests lie with this second group of investors. We are more interested in a company's ability to sustain and/or grow their dividend stream. We do not expect a company to pay out the full amount of earnings generated by operations. As investors, we know that the larger the dividend component of total investment return, the lower the variability of stock prices. Thus, there is an inherent conflict in selecting stocks based on dividend yield and the potential to grow dividends.
Banks, insurance companies and other financial service firms pose a particular challenge in attempting to value them. The nature of financial service firms makes it difficult to define both debt and reinvestments, making the estimation of cash flows very difficult. Secondly, the regulatory environment has an impact on valuation and must be considered.
In financial service firms, debt is not considered a source of capital. In these firms, capital is defined in terms of equity. The regulatory authorities evaluate equity capital ratios of banks and insurance companies. The capital structure of financial service firms makes it very difficult to value these companies on the basis of cash flow.
We choose to value the equity of financial service firms by use of the price-to-book value method. The price-to-book value for a financial service firm is the ratio of the price per share to the book value of equity per share. In this definition, PBV is determined by expected growth rate in earnings per share, the dividend payout ratio, the cost of equity and the return on equity. Other things being equal, higher growth rates in earnings, higher payout ratios, lower costs of equity and higher returns on equity should all result in higher price to book ratios. Of the four variables mentioned here, return on equity has the biggest impact on the price-to-book ratio.
In our model, we place our emphasis on identifying companies with low payout ratios (with room to grow the dividend) and the means to sustain dividends over rough patches. We expect our companies to have manageable levels of debt as defined by interest coverage. In all our articles we have emphasized the superiority of cash flows over earnings. Dividends are paid in cash and not from "earnings." To make a payment, a company must either have the cash or borrow it. We require our companies to generate cash flows that exceed reported earnings. Earnings growth is not enough for us. Since we base our valuation method on book value, we require that our companies grow equity year-over-year. We also require growth in cash flow and earnings.
The following table lists those financial service companies that meet our basic screening requirements. The table shows PBV ratios and ROE ratios for these companies. We also include our predicted or expected PBV ratio for each firm. These predicted ratios are based on estimates of the drivers for PBV, i.e. earnings growth rates, dividend payout, beta and return on equity.
The focus of this article is to identify potentially undervalued dividend paying companies in the financial services sector utilizing price to book ratios. We did not discuss dividend yields or dividend growth rates, for the sake of this article, of secondary concern. Yields and growth rates are very important variables when evaluating any equity investment.