Ben Graham's Explanation For The Dividend Champions' Premium Valuation

Includes: HSY, PEP, SHW, SON, SPY
by: Eli Inkrot


As a group, longstanding dividend payers routinely demand a premium valuation in the market.

Conventional wisdom suggests that this is a result of the inherent quality that is involved with owning these companies.

Ben Graham backs this view up in his book, “The Intelligent Investor”.

Additionally, this article contends that the higher valuations result from an even more fundamental reason.

In some of my recent articles I have been focusing on "higher valuation" companies. Specifically, I took a look at the Hershey Company (NYSE:HSY) and Sherwin-Williams (NYSE:SHW). With the Hershey example, I concluded that the company's higher valuation appeared to be somewhat normal -- Hershey always seems to trade at a premium valuation. On the other hand, Sherwin-Williams is exchanging hands at a previously uncharted price-to-earnings mark and thus caution might be the word. The point of each commentary was to compare the current valuation multiple with what might be reasonable both historically and on an ongoing basis.

This article is intended to be a coverall for "high valuation" dividend payers. What better way to aggregate this group then to look at the most consistent of the bunch - David Fish's list of Dividend Champions. In viewing his most recent list you can see that there are 106 companies that have not only paid but also increased their dividend payouts for at least 25 consecutive years. We all know the names: the Coca-Colas (NYSE:KO), Procter & Gambles (NYSE:PG) and Johnson & Johnsons (NYSE:JNJ) of the world.

Collectively, as of David's last update, these companies had an average trailing P/E ratio of nearly 21. This compares to something in the 17 to 19 range for the S&P 500 index (NYSEARCA:SPY) depending on how it is calculated. Additionally, the Dividend Champions have an average blended P/E of about 19.3 against the S&P's mark of roughly 16.9. Assuredly you can argue about the appropriate universe with which to compare, but I don't believe it's all that controversial to suggest the Dividend Champions command a slight premium.

In order to find an explanation for this, one need not look further than page 294 of the updated version Ben Graham's classic book, The Intelligent Investor. In Chapter 11 -- Security Analysis For The Lay Investor -- Graham details 5 factors that affect a company's capitalization rate. The first three are: "general long-term prospects," 'management" and "financial strength." The fourth factor Graham lists directly pertains to this discussion:

"4. Dividend Record. One of the most persuasive tests of high quality is an uninterrupted record of dividend payments going back over many years. We think that a record of continuous dividend payments for the last 20 years or more is an important plus factor in the company's quality rating. Indeed the defensive investor might be justified in limiting his purchases to those meeting this test."

Now it is true that Graham indicates 20 years (without the additional qualification of a growing payout) instead of 25 consecutive years. Yet consider that even the Contenders and Challengers on David's list have average trailing P/E ratios above 20. The premium remains intact. The reasoning is relatively intuitive: higher quality should equal higher valuation. It's no different than organic products commanding a higher price at the grocery store or any one of hundreds of name brands routinely selling for much more than their generic counterparts.

However, I believe that there is more than just the intuitive reasoning behind the Champions' premium valuation. My contention is that, on some level, the premium is a result of paying a dividend itself. A lot of people like to focus on the 4th factor Graham lists, but I consider the 5th factor to be just important. Here Graham's wording is less certain, yet the realization is lasting. The 5th factor affecting the capitalization rate is the "current dividend rate."

Conceptually, you can see why someone might pay more for PepsiCo (NYSE:PEP), for instance. It dominates the snack shelf aisle and people are routinely willing to pay a premium for their products. Thus this could carry over to the stock as well: it's a quality company and people are willing to pay a premium. It's a solid reason. Yet I believe just one of many. On a mathematical level, it shouldn't be a surprise at all. PepsiCo is presently paying out about 60% of its earnings in the form of dividends. If you're paying out 60% (or more) of your earnings, one of two things has to happen: it requires either a relatively high dividend yield or a relatively high P/E ratio; the three are interrelated.

Let's take the numbers from Seeking Alpha: PepsiCo pays a dividend of $2.62 and has earnings per share of $4.42, roughly equaling the previously described 60% payout ratio. With a price around $90, this means the shares trade with a 2.9% dividend yield and a 20 P/E ratio. Now, you might believe that either the yield or the multiple is too high; that they should come down a bit. Yet the two are inversely related. If you believe the yield should be 2.5%, this requires a P/E ratio of nearly 24. If you believe the P/E ratio should decline -- to say 15 -- this requires a dividend yield of about 4%. It just so happens that 3% is a reasonable dividend yield in today's environment, and thus a company that pays out 60% of its profits with this yield must trade at 20 times earnings.

Obviously this applies to any company; take Kimberly-Clark (NYSE:KMB) or Sonoco Products (NYSE:SON), each paying out about 60% of their profits. Both companies have roughly 3% yields and thus P/E ratios of about 20. In order for the P/E to go down, the yield must go up. In addition to the concept of quality, you might imagine that this is why you rarely see the Dividend Champions -- especially those with relatively high payout ratios -- trading at 10 times earnings, for example. There's a counteracting force at play. With a 60% payout ratio, a 10 P/E multiple would require a 6% dividend yield.

In the end, the idea of a premium valuation being tied to a premium company is the intuitive benchmark -- as indicated in Graham's 4th factor that affects the P/E multiple. Yet don't forget to look at his 5th factor either -- the idea that simply paying a dividend creates a compensating factor. Having a rational expectation about both yield and multiple should help you think about the "higher" valuations. The likelihood of a Colgate-Palmolive (NYSE:CL), especially today, trading with a yield above 4% appears small. Thus this mathematically forces a "premium" valuation upon the company. Quality or arithmetic, intuitive or mechanical, any way you slice it, the premium for consistent dividends appears lasting.

Disclosure: The author is long KO, PEP, JNJ, PG. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.