The Price Is Right: Dividend Growth And Yield Relative Valuation, Part 1

May 26, 2012 9:16 PM ET
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Contributor Since 2012

I am a private investor wtih 25 years experience, I have an Engineering degree with some Economics courses. My experience covers many styles: Stocks, Bonds, Options, High Yield, Munis, Growth, Value, Fundamental, Momentum, Funds (CEF/OEF/ETF). I follow macro-economics and strategy as well as individual companies. I also have an interest in theories of money creation and banking.

Series, Part 1: The Question

This is the first in a series of Instablogs to introduce the concepts and analysis on one of the key problems of dividend growth investing: What is the right price to pay for a growing yield?

Based on the discussions I have seen, experienced dividend growth investors instinctively understand that even a company with excellent dividend growth prospects may be overvalued at a given point in time. Alternatively, it may be undervalued. I have conducted some in-depth research into this topic and come to some interesting conclusions.

Let us take the example of two DG (Dividend Growth) stocks. Assume both have the same 10 year dividend growth history of 10% per year, and both have equally strong business position and prospects with a reasonable forecast of 10% growth going forward. If the yields are as follows:

A) 3% Yield, 10% Dividend Growth Rate

B) 2% Yield, 10% Dividend Growth Rate

All else being equal, it is obvious the choice is A.

I will assume throughout these blogs that the risk and confidence in the growth rates is equal. Naturally this can never be exactly the case, but it is a necessary step for my financial analysis. Later I will explain why I am using that approach in a dedicated blog.

Now let us make the choice harder:

A) 3% Yield, 10% Dividend Growth Rate

B) 2% Yield, 15% Dividend Growth Rate

Most of us with experience instinctively know that if we are comparing a 2% yield 20% growth to 3% yield 5% growth, the 2% is the likely winner, assuming that the risk and confidence in those projections are equal. But when yields and growth are closer, it gets more difficult to discern. Unfortunately this type of situation is very common for high quality DG stocks.

A further complication is that yields and rates in general often move in concert. The same company with the same growth rate and prospects/risk may yield 5% at one time, and then 2% a number of years later in different market conditions. What accounts for this difference, and is there a way to know whether the 5% or 2% yield rate is a buy or sell indicator?

In the following Instablog series I will use a detailed 50-year case study of an interesting Dividend Growth stock, IBM, to illustrate some of the concepts I have worked out. This should be of interest to anyone interested in Dividend Growth, Bonds, Preferred, Real Estate, CEF, and other similar types of income investing. Note: I am writing this as a series of blogs since the full article would be too long and I would like feedback as I go. Please be gentle, but do not hold back.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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