Investing in blue-chip dividend growth stocks such as the Dividend Aristocrats or Champions has become very popular with retirees. This is understandable considering the low interest rate environment we find ourselves in. Traditional fixed income investments do not currently offer enough yield for the retired investor to live on. Consequently, current low interest rates, coupled with the possibility of a steadily increasing level of dividend income have made dividend growth stocks a viable and even attractive alternative.
When choosing the appropriate dividend growth stock, many dividend growth investors will rightfully focus on the company’s dividend record and dividend growth more than they will its price history. However, this can be a detrimental practice if the investor ignores valuation. Unfortunately, this is not an uncommon practice. There are many dividend growth investors who will invest in a blue-chip Dividend Aristocrat even when it is overvalued at the time. Many of these investors argue that since the dividend is what is of paramount importance, being out of a blue-chip will cause them to generate less dividend income. To these investors, a dividend missed is a dividend lost.
Ironically, that can be a fallacious argument because being willing to only invest at fair value can actually produce more dividend income over the long run, not less. Later I will provide real-life examples of how this works. Nevertheless, the primary thesis behind this article is to review the power, protection and benefit of focusing on valuation before you invest your hard earned money.
The Essence of Valuation
There is truth behind the idea that the calculation of fair value is somewhat subjective, and/or not a perfect science. On the other hand, there are important principles underpinning the calculation of valuation that are valid and definable. The subjective part rests in the reality that an important component of the calculation of fair value is future based.
Stated differently, assessing the fair valuation of a stock is comprised of and calculated based on past, present and future operating results. The past and present parts are relatively easy to ascertain, it’s the future part that is tricky. Nevertheless, fair valuation can, and I submit should be a major consideration regarding the purchase of a common stock – dividend paying or not. Therefore, I would like to share some thoughts that Ben Graham, the father of value investing, offered on the subject of the intrinsic value of a common stock.
In Security Analysis, Graham said this:
“This does not mean that all common stocks with the same average earnings should have the same value. The common-stock investor (ie the conservative buyer) will properly accord a more liberal valuation to those which have current earnings above the average, or which may reasonably be considered to possess better than average prospects.
But it is of the essence of our viewpoint that some moderate upper limit must in every case be placed on the multiplier in order to stay within the bounds of conservative valuation.
We would suggest that about sixteen times average earnings is as high a price as can be paid in an investment purchase in common stock.”
Note in the quote above that Ben Graham suggested a P/E ratio of 16 as the upper limit of what a prudent investor should rationally pay for a stock. However, he did suggest that a more liberal approach could be made if the growth rate was high enough. But even then, he considered a P/E ratio of 16 as an upper limit.
Although it may be confusing, or difficult to wrap your mind around the idea, that both a 5% grower and a 10% grower will utilize the same price earnings ratio to identify intrinsic value, there is a logical explanation. Buying a company at a sound valuation does not determine the rate of return you can earn. Instead, it means that you are making a sound purchase based on a rationally expected valuation that the marketplace will apply to a legitimate operating enterprise (a company or stock).
The rate of return that an investor should logically expect to receive will be more a function of the rate of change of earnings growth that a given company is capable of generating. The faster the earnings growth rate, the higher your return expectations should be. I intend to demonstrate that when you invest at intrinsic value levels, your long-term rate of return will inevitably be a function of your company’s earnings growth. Stated more directly, if you buy a 5% grower at intrinsic value, your long-term capital appreciation expectation should be 5%. If the company pays a dividend, you can add that to your total return. In contrast, if you buy a 10% grower at intrinsic value, your long-term capital appreciation expectation should be 10%, plus dividends as above.
This last statement is predicated on what I consider to be the reality that common stocks will inevitably be priced at fair valuation levels in the long run. Over the short run, price and value can become disconnected, sometimes significantly, and sometimes over an extended period of time. Nevertheless, inevitably, markets will become rational and fair valuation will manifest.
The point is that intrinsic value will inevitably manifest over time. Therefore, if you adhere to investing under the principles of intrinsic value, you will be making sound and intelligent decisions that provide a margin of safety and compensate you for the risk you take. However, your investment receives its value from the cash flow it produces. The higher the growth rate, the more cash flows the company will produce, and the higher the rate of return that can be expected as a result. But perhaps most fundamentally, the reason the same P/E ratio applies to various growth rates has to do with minimum values based on yield. With common stocks it’s earnings yield, however, with bonds there’s a related interest yield.
There are sound business and economic principles behind the concept of valuation. Ben Graham did more than give us a formula for calculating intrinsic value, he taught us that valuation matters a lot. When you pay more than sound valuation indicates, you will be taking more risk for potentially a much lower return than you deserve. Conversely, if you buy at a bargain price, your risk will be lower and your future returns potentially higher.
But perhaps most pertinent to this article, if you come across a blue-chip dividend growth stock that you really like but is simultaneously overvalued, I am suggesting that it will pay you to wait for fair value before you invest. But the part that is perhaps most misunderstood is that not only will your long-term total return be higher, but if you’re patient enough to wait for fair value, your long-term dividend income will be higher as well.
Many people believe that the sooner you invest in a blue-chip like a Dividend Aristocrat, the more dividend income you will receive. They believe that time in produces more dividends, but I suggest that they are wrong to think that. Being only willing to invest at fair value will produce more dividends in the long run, as I will demonstrate later.
Getting back to Ben Graham for a moment, he was very focused on a P/E ratio of 15 as a fair valuation threshold. In Security Analysis he presented