As the stock market continues its relentless advance, attractive valuations are getting harder and harder to find. This is especially true for the highest quality blue-chip dividend growth stocks. Perhaps more importantly, in addition to the market’s relentless advance, there has also been a clear flight to quality – especially with dividend growth stocks. Therefore, the vast majority of the best-of-breed blue-chip dividend paying stocks are currently trading at elevated levels. In other words, finding high quality and value is very rare today in the dividend growth segment.
This presents a conundrum for the prudent dividend growth investor with money available for investment. Prudence suggests that the quality of the companies chosen for their portfolios is extremely important. It only makes sense to try to invest in the highest quality companies you can find. However, the prudent dividend growth investor also needs to ask and answer another important question. At what point does excessive valuation turn quality into high risk investments? After all, the idea behind investing in quality is to lower risk.
Furthermore, being prudent implies being sensible regarding the valuations you should be willing to pay for even the highest-quality company. The intelligent value investor recognizes that you can overpay for even the best company. Moreover, they understand that investing when valuation is too high reduces the opportunity for attractive returns and simultaneously increases risk. Taking on more risk for lower potential returns is the antithesis of prudent value investing.
However, this poses a second important question that the prudent value investor must also ask and answer. How much quality should you be willing to forgo? Asked differently, what is the proper balance between quality and value? In other words, at what point does attractive valuation compensate you for the risk of investing in lesser quality securities? These are difficult questions for the prudent investor to answer. However, I will attempt to provide some insights into correctly answering these questions with this article.
Dividend Growth Stocks on David Fish’s lists of Champions and Contenders
In my previous article titled “These Are The Only Dividend Aristocrats I Would Consider Today” I identified only 7 out of 50 Dividend Aristocrats I would consider investing in currently. This prestigious list of dividend growth stocks covers what is generally considered the crème de la crème of dividend growth stocks. However, author David Fish produces and tracks 3 additional lists of dividend growth stocks with histories of increasing their dividends each year known as the CCC lists.
His Dividend Champions have increased their dividend payout for at least 25 years similar to the Dividend Aristocrats list. However, his list includes 108 Champions versus only 50 Aristocrats. Nevertheless, the majority of companies found in his Dividend Champions are generally high quality dividend growth stocks.
His second list he calls Dividend Contenders, which is comprised of companies that have increased their dividends for 10 to 24 straight years. This list of reliable dividend growth stocks is currently made up of 242 companies. Generally speaking, this is also a list of high-quality dividend growth stocks, but arguably, the quality of the companies on this list would in the general sense not be equal to the Champions or Aristocrats constituents.
Finally, David Fish offers his third list of up-and-coming potential dividend stars known as the Challengers. There are 428 companies currently on this list representing dividend growth stocks that have increased their dividends for 5 to 9 straight years. With this article, I only surveyed the Champions and Contenders looking for attractive valuation. Consistent with what I found when I surveyed the Dividend Aristocrats in my previous article, I only found 6 additional Dividend Champions (excluding any of the duplicate Aristocrats I presented in my previous article) that I considered attractive in today’s elevated market.
On the other hand, my cursory review did identify 32 Dividend Challengers that appear attractively valued today. Consequently, this leads me to conclude that the best values for the dividend growth investor might currently be found in the Dividend Challengers. However, that does not automatically imply that the research candidates on this list are of lower quality. On the other hand, some are of lower quality and some are not. Finding impeccable quality available at attractive valuations is currently challenging, to say the least. Nevertheless, the one common denominator with all these research candidates is that they have all increased their dividends each year for the past decade or more.
Why a 15 P/E Ratio is a Rational Valuation Reference
The P/E ratio of 15 is an extremely important and rational valuation reference if you understand the significance of what this metric really means. First and foremost, the P/E ratio is not just a mere number or statistic. It is actually a mathematical calculation that represents the value that a given company’s earnings are offering you as an investor. In my most recent article, a comment was made suggesting that applying a P/E ratio of 15 to all companies was overly simplistic. With this article I intend to demonstrate why that is not true for most companies.
As rational investors, we are always attempting to earn the highest possible returns we can at the lowest levels of risk we can assume. Therefore, a rational way to look at investing in a stock is to determine what rate of return the company’s earnings power is offering you at a given level of valuation. As I’ve written many times before, the easiest way to determine this is to simply calculate the earnings yield represented by the company’s P/E ratio. This is accomplished by inverting the formula from price to earnings (P/E) to earnings to price (E/P) which gives you the earnings yield. Therefore, a 15 P/E ratio represents an earnings yield of approximately 6.66%. A P/E ratio of 20 represents an earnings yield of 5% and a P/E ratio of 30 represents an earnings yield of 3.33%.
Consequently, when you are evaluating the P/E ratio of a given company, in the back of your mind you should be asking what yield is the company’s current earnings offering me? An earnings yield of 6% to 7% (P/E ratio 15) would be the minimum that a rational investor should expect given the risk associated with investing in common stocks. This is especially pronounced when you consider that as a passive shareholder, you will not be receiving all of the company’s earnings.
For example, if the company’s dividend payout ratio was 50% of earnings, this would imply a current dividend yield of 3.33%. Any return you would expect above that would have to come from capital appreciation potential. Of course, a lower dividend payout ratio would indicate a lower dividend yield -and vice versa. However, the point is that the earnings yield and the dividend yield represents the current returns that the company’s earnings power is affording you at any given valuation.
What I am suggesting here is that when you are seeing a company trading at a certain P/E ratio, you should immediately ask yourself what is the earnings yield, and is it high enough to entice me to invest. Obviously, this also suggests that the lower the P/E ratio you pay to invest in a stock, the higher the earnings yield that valuation represents. With all investing, higher