I have been trying to explain to friends and family how I go about valuing a stock and its potential for inclusion in my wife and my portfolio. The first thing that you must do is carefully consider the current and long term prospects for the company in relation to the always changing trends in the economy. For example, movies are now being delivered digitally, with an ever increasing amount of this content coming via streaming. How will this affect the future of television, content producers, and internet providers? I don't want to get into that since it would be another long post, but am just trying to point out that we don't live in a vacuum; the world is an ever changing place.
With this article I am going to evaluate how the growth of earnings and dividends have a major impact on how an investment grows, from high growth, no dividend stocks to low growth, high yield stocks. This is a simple model so we will use the following constants:
- The price-to-earnings ratio (P/E), dividend yield, and company growth rates will not change (not realistic, but otherwise the math gets overly complicated for our purpose)
- Dividends will grow at the same rate as earnings and the payout ratio, the percentage of earnings returned to shareholders via dividends, will not change (redundant to the first bullet point, but not necessarily intuitively obvious)
- The market will assign a P/E ratio of two times the total of the earnings growth rate added to the dividend yield. For example, a company that pays a 3% dividend and grows earnings at 6% will have a P/E of 18 since (3+6)*2=18
- All companies will start with $1 of annual earnings
- All dividends are reinvested
- The original investment is $10,000
- Share prices are constant for the entire year (again, not realistic, but simplifies the math)
Investors fall into different groups based on their objectives. Some investors fall into the growth camp and concentrate of capital gains, while others concentrate of increasing income via dividends. There are many types of stocks, however, so we are going to look at four examples, as follows:
- High growth (20%), no yield, assigned P/E of 40
- High growth (15%), low yield (1%), assigned P/E of 32
- Medium growth (6%), medium yield (3%), assigned P/E of 18
- Low growth (2%), high yield (%5), assigned P/E of 14
Note that the percentage growth and dividends are annual rates, and that we will be considering only annual share price and dividend changes. Again, the numbers will vary slightly if we were to assume quarter earnings, share price, and dividend changes, but the added complexity will not significantly affect our conclusions. SFRD in the tables below is short for shares from reinvested dividends, which is simply the amount of dividends collected in an given year divided by the share price. These are added to the share count since we are reinvesting dividends in these examples.
High growth (20%), no yield, assigned P/E of 40
The following table shows the progression of earnings and valuation since this example is for a stock without any corresponding dividends. Note the rapid raise in valuation. Companies that fit this description will have been around long enough to have developed a market, such as Alphabet (formerly known as Google) or Netflix. New companies are hard to evaluate before a market is developed. Imagine that I have designed and manufactured a product and sold a single unit last year. This year I have sold two units, so my increase in sales is 100 per cent! Woo-hoo! Right, that means very little to an investor since we have no idea if I will sell any units next year. If you are unclear on this concept, I suggest that you watch "Dragon's Den" or "Shark Tank". At any rate, here is a spreadsheet showing how the stock soars when a company can deliver 20% growth in earnings for an entire decade:
Nice, eh? Our original $10,000 has turned into almost $62,000 in only 10 years. If you can accurately predict which fast growing companies will continue to increase earnings for years at a time, you can become very rich. That is much easier said than done, and any deviations will be severely punished by the stock market. This type of company will tend to be more speculative in nature, can make great investments in a bull market, and terrible investments in a bear market.
High growth (15%), low yield (1%), assigned P/E of 32
Companies in this category still have a lot of room to grow, but management has decided to start paying dividends to share holders. Star Bucks and Visa are examples. Note that as these companies continue to mature, they tend to become medium growth, medium yield as markets mature and the pay-out ratio increases.
Here we see that the share price, dividends, and total shares owned all grow nicely due to the 15% growth rate. The dividends more than quadruple from $100 to almost $447 annually, resulting in a yield-on-cost (YOC) of nearly 4.5%. A lot of dividend investors consider YOC an important metric since it measures the amount of income someone receives from a given investment. The increase in the total value of this investment is impressive at $45,000, but not as good as for our first case due to the lower growth rate. You will notice that the growth rate is a key to evaluating stocks.
Medium growth (6%), medium yield (3%), assigned P/E of 18
Now we are looking at mature companies with products that are consistently in demand, but not necessarily growing like the earlier cases. My favorite companies in this category are the so-called blue chips. Consider how Johnson & Johnson or Coca-Cola sell Band-Aids or Coke year after year. Consumer staples and health care products, or even energy firms such as ExxonMobil, are places to look.
Notice again how the end value is decreasing due to the lower growth rate, but the dividends grow nicely and the YOC exceeds 7%. Our original investment has now grown to almost $25,000. So, the return appears to be lower, but we have higher income, and particularly if we invest in blue chip companies, less risk the the high growth stocks.
Low growth (2%), high yield (%5), assigned P/E of 14
Utilities and telecoms, such as DTE Energy and AT&T, are examples of low growth, high yield investments. Another category that you may investigate is the Real Estate Investment Trust, or REIT. Investinganswers.com defines REITs as follows:
A real estate investment trust (REIT) is a closed-end investment company that owns assets related to real estate such as buildings, land and real estate securities. REITs sell on the major stock market exchanges just like common stock.
In this example, our initial investment and our dividends basically double in the 10 year period after purchase. The YOC nearly reaches 10%. For investors looking for current income, or for those who will need this type of income in the future, the low growth, high yield stocks are very appealing. You will want to stay away from the so-called value traps, however, that are created when a company with a significant yield experiences hard times that put it in jeopardy of a dividend cut or elimination. Or companies in areas of the economy that investors in general consider inherently more risky, where it is not uncommon to see a 10% yield at the time of investment. Remember, the market wants to be rewarded for risk, and your job is to determine how much you are willing to take. You don't want to lose sleep or panic because of your investments.
Maximum capital gains are acheived by investing in companies that consistently grow earnings at a rate above the market average. Maximum income is usually obtained by investing in companies with a high initial yield that are steadily growing the dividends. Other factors, such as P/E expansion or contraction, or economic slow downs, can also affect the portfolio. Successful investors can use a mix of high growth stocks and those that pay dividends, depending on their investing time frame and portfolio objectives. I personally prefer mostly blue chip stocks paying dividends, but also have a small amount of high growth stocks as a further hedge against inflation.
Please let me know if you would like to see more of this type of blog, or if you have questions on the content above.
Disclosure: I am/we are long SBUX, V, JNJ, KO, XOM, T, AND GOOGL.