Dividend Champions/Aristocrats are the go-to dividend paying stocks for prudent investors desirous of a safe, predictable and growing stream of income on the common stock portion of their retirement portfolios.  As most investors are aware, in order to be classified as a Dividend Champion/Aristocrat a company must meet the stern test of consecutively increasing their dividend for 25 years or longer.  Of all the dividend paying stocks in the universe, only a select few make these prestigious lists.

However, the popularity of Dividend Champions/Aristocrats often presents a conundrum to value-oriented dividend growth investors.  These best-of-breed dividend paying stalwarts are rare to find at attractive or prudent valuations.  Nevertheless, since I am a fervent believer that you make your money on the buy side, high quality and an impeccable dividend record are not enough for me.

Before I am willing to invest in any company, Dividend Champion/Aristocrat or not, the company must be available at a prudent and attractive valuation.  Of the more than 50 Dividend Aristocrats, and more than 100 Dividend Champions, I only found 10 that I considered currently attractive based on valuation.

Price Is What You Pay – Value Is What You Get

In December 2010, I started a series of articles where I presented the principles of valuation.  Since I believe that principles of valuation are timeless, I offer the following excerpts from that series in order to revisit some of the more important principles, benefits and aspects of investing at fair value.

In part 1 of that three-part series found here I presented the important principle that distinguishes the difference between price and value:

“Price Is What You Pay. Value Is What You Get.

The venerable investor Warren Buffett has a real knack of putting complex concepts and ideas into simple and easily understood terms. In my opinion, his quote, “Price is what you pay. Value is what you get” is one of the more profound and important statements he has ever uttered. If truly understood, these simple words represent perhaps some of the most important bits of investment wisdom that an investor could ever receive.

The concept of value represents the key to receiving the full benefit that these wise words provide. Knowing the price you pay is simple and straightforward. And, although many have an intuitive understanding of value, its deeper meaning is often only vaguely comprehended. Anyone who has truly made the effort to study Warren Buffett’s investment philosophy understands that receiving value on the money he invests is of high importance to him.

So how do you know, when buying a stock, if you’re getting value or not for your money?  I contend that the answer lies in the amount of cash flow (earnings) that the business you purchase is capable of generating on your behalf. And regardless of how much cash flow the business can generate for you, its value to you will be greatly impacted by the price you pay to obtain it. If you pay too much you get very little value, but if you pay too little then the value you receive is greatly increased.

Therefore, if value is what you’re looking for, then it’s important that your attention be placed on the potential cash flows that you’re expecting to receive. Unfortunately, few investors possess the presence of mind to focus on this critical element. Instead, investor attention is more commonly and intensely placed on stock price and its movement. A rising stock price is usually considered to be good, and a falling stock price considered bad.”

At this point, I would like to focus the reader on an important subtlety about valuation that I alluded to in the above excerpt. Notice that I discussed cash flows, but also made a reference to earnings.  As I will illustrate later, earnings are an important valuation metric, because in the long run earnings drive stock price, which is the source of capital appreciation.  However, when investing in dividend paying stocks, cash flows are equally if not more important because they represent a company’s ability to cover their dividends.  Moreover, there are certain companies where the correlation between cash flow and stock price is more distinct than the correlation between earnings and stock price.

Dividend payout ratios are typically expressed as a percentage of earnings.  However, they can also be expressed as a percentage of cash flows.  Additionally, the reader should also recognize that a company’s cash flow per share will normally be higher than its earnings per share when examining a high-quality company producing consistency with both metrics.  Consequently, many best-of-breed dividend paying stalwarts command a premium valuation based on earnings, but will appear more attractively valued based on cash flows.  This important point will be elaborated on later in the article.

Nevertheless, in part 2 of the 3 part series I wrote in 2010 found here I discussed the utilization of the P/E ratio as a first step in the valuation process.  In the following excerpt, I discussed the relevance of a P/E ratio of 15 as a reasonable first blush valuation level, its limitations, and I also again alluded to the notion that certain companies routinely command premium valuations above that benchmark level.

“In Part 1, I also offered the idea that a P/E ratio of 15 was appropriate for companies whose growth rates fell in the range of 0% to 15%. In other words, in addition to the fact that the P/E ratio of 15 has been the average for indices like the S&P 500, there is also a logical and mathematical reality behind its validity. However, although a P/E ratio of 15 was an appropriate valuation to pay for growth of up to 15%, I also pointed out that it did not necessarily indicate the rate of return investors should expect to receive.

Also, the 15 P/E ratio should not be looked at as an absolute, instead it should be viewed as a baseline barometer for fair value. In other words, the 15 P/E is a good starting point guideline to ensure that you are not overpaying and taking too much risk. Consequently, anytime you come across a moderately growing company (5%-15%), whether a blue-chip or even a moderate to high dividend payer that is trading at a P/E ratio above 15 then caution is called for. However, there are certain companies that will always command a premium valuation.”

In part 3 of my series on the principles of valuation found here I discussed the key, as well as the importance that valuation plays regarding the avoidance of making obvious mistakes.

“In this, my 12th and final installment of my series of articles on when and why to buy a stock, I will focus on how to use the principles of valuation to avoid obvious mistakes. As mentioned in previous articles, investing is never a game of perfect. The best that an investor can hope for is to make sound long-term decisions, with the majority of them working out to their benefit in the end.

However, investing is a very complex endeavor, and mistakes are inevitable. Therefore, it’s imperative that the obvious mistakes which can and should be avoided are avoided.

Obviously, mistakes usually occur when the market or people are caught up in emotion. As we all know, the primary emotional responses that can affect investor behavior are fear and greed. When gripped by the hype from greed or by the hysteria from fear, investors rarely behave rationally. It is

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