Dividend Aristocrats are companies in the S&P 500 that have increased dividends every year for the last 25 straight years. These Aristocrats companies have often robust business models and have done quite well compared to the rest of the market. For selecting the top-5 we use the theory that for stable business dividend stocks, their dividend yields tend to return to the historical average over time. In this case, a stock is undervalued when the current yield is higher than the 5-year dividend yield average.
For example, A. O. Smith Corporation’s (AOS) current dividend yield of 1.70% is 50.4% above its 5-year average of 1.13%. This indicates that this dividend stock is (current yield – average yield)/current yield = 33.5% undervalued. Assuming the dividend payout remains the same, the share price must increase to lower the dividend yield.
To return to the historical average dividend yield, the stock price has to increase by 50.4% in the next 5 years. This translates in an extra annual 8.5% increase for the stock in the next 5 years.
One way to calculate the potential total return for AOS, is to add up the historical average 5-year yield and the 5 years Free Cash Flow (FCF) growth per year per share.
Potential total return = historical dividend yield + FCF growth + undervalued correction
For AOS the potential total return = 1.13% + 15.60% + 8.5%
Looking at the flip side of potential total returns are potential risk indicators. To validate the valuation and forecast, we check the forward P/E ratio compared to the historical and sector average. Also, the FCF growth percentage should be confirmed by the dividend growth rate percentage over the last 5 years.
Furthermore, we use a unique indicator to compare and rank the dividend stocks, because next to dividend the price performance and risk are also important. For a risk indication, we use the “loss ratio”.
The “loss ratio” is a complex calculation, on a high-level, this calculation is based on a weighted average of the months with a negative price-return over the past 10 years. The most recent negative monthly return will have more impact than the older negative months e.g. from 5 years ago.
Top 5 Dividend Aristocrats To Buy
Based on the investment theory that dividend yields tend to return to the historical average over time, below the top 5 undervalued Dividend Aristocrats per February 15th.
The table below list the current dividend yield, the 5-year historical average dividend, the percentage discount compared to the fair value, the expected annual correction due to the undervaluation, the FCF growth percentage, the 5-year historical dividend growth (CAGR) and at the end the potential annual total return.
Let’s have a close look at those 5 stocks.
A.O. Smith Corporation (AOS) is active in the industrial sector and became in 2018 a member of the Dividend Aristocrat family. AOS's current dividend yield of 1.70% is 51% above its 5-year average of 1.13%, which could mean a 33.5% undervaluation. AOS's forward P/E ratio of 19.1 is below its 5-year average of 22.7 and above the Industrials sector average of 16.2. The stock is recovering from its mid-December low.
Biotech company AbbVie’s (ABBV) dividend growth rate over the last 5 years is with 20% very fast. Based on the 47 percent difference between the current dividend yield of 5.29% and its 5 years average of 3.59%, the stock is undervalued and has a potential of + 32.1%. ABBV's forward P/E ratio of 9.3 is well below its 5-year average of 12.8 and also below the Healthcare sector average of 17.8.
AbbVie is currently trading just above its 52-week low of $77.14.
Illinois Tool Works’ (ITW) forward P/E ratio of 18.0 is close to its 5-year average of 18.5, suggesting that ITW could be fairly priced. Based on the current dividend yield of 2.77% compared to the 5-year average of 2.09%, there is some room for growth.
Walgreens Boots Alliance (WBA) is one of the largest pharmacy retailers and drug distributors. WBA’s FCF 5-year growth forecast of 19% is well above the 8% historical dividend growth, which is a good indication for the future growth being realistic. The payout ratio of WBA is 27% which is a reasonable safe payout ratio for this stock and the sector. WBA’s dividend increased for 42 consecutive years now.
Archer-Daniels-Midland Company (ADM) is undervalued based on its current dividend yield of 3.33% and its 5-year average of 2.78%, which is 20% below the current yield. Both ADM’s current payout ratio of 38% and forecast 39% for next year are nothing to worry about. Also, the earnings per share $3.50 ((current)) and $3.56 ((next 12 months)) are positive good metric for further growth.
Return versus risk
Based on the theory that dividend yields tend to return to the historical average over time, we selected the top 5 dividend aristocrats and indicated their potential return based on the undervalued principle. Another aspect that comes into play, when investing is the risk-factor. Calculating the loss-ratio is a way to rank the stocks.
In the diagram below the 5 dividend aristocrats are plotted with their potential return and loss-ratio. As a reference also the metrics of the Dow-Jones 30 (DJI) is added in the chart. The “best place” to be is a low risk, close to 1.0 and a high potential total return, so the left top corner.
Looking at the data, all 5 Dividend Aristocrats could out-perform the Dow Jones, but the risk is also higher. When ranking the top-5 plotted in the diagram, the order would be AOS, ABBV and ITW given the total return and same risk value. ADM would be ranked last since the risk value is higher and the potential return the lowest.
The Dividend Aristocrats presented can be considered the best Dividend Aristocrats stocks you can buy today, based on the described investment theory of “undervalued” stocks constructed on dividend yield. All 5 dividend stocks display above +15% potential total return, which could mean that they will more than double in the next 5 years.
Disclosure: I am/we are long NOBL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.