We’ve talked a fair bit about valuing dividend stocks, giving them a health check up, and holding them in a portfolio for the long term. But there’s one key factor we’ve missed out – estimation.
See, valuation hinges on your ability to estimate. If you can pick a stock and estimate its rate of growth over the long term, you can easily figure out how much the stock is worth. At that point, you have to buy the stock for less than it’s worth.
Stock commentators and financial experts spend a lot of time telling you about the best strategy for investments and finding the highest quality stocks. Growth, of course, is important, but most experts focus too much on the way you can use an estimated growth rate rather than clearly tell you how to estimate it in the first place.
Here’s what you need to know:
Growth is the key
There’s no denying growth is essential. The whole point of investing is to see your investments grow over time. Even if you’re the sort of investor who wants absolute security and a stock with a steady dividend, you require growth to stay ahead of inflation. Dividend growth, essentially, ensures your cash flows don’t lose purchasing power over the years.
That’s not all. Growth rates are an essential element of any valuation method. Last time when we discussed the Dividend Discount Model or the Gordon Growth Model, there were only three elements in the equation – the current dividend, the risk-free rate of return, and the growth rate. Of those three elements, only one needs to be ‘guessed’. You can look up the current dividend and the yield on government bonds online. You cannot, however, sign into Google and find out the expected rate of dividend growth for each stock you consider.
So, learning how to estimate the dividend growth rate is crucial for any income-seeking investor.
The best place to start is the most logical. The most logical way to estimate dividend growth is to study the fundamentals of the company and extrapolate that into the near future. Financial experts use a simple method that involves two elements – the Return on Equity (ROE) and the retention ratio.
ROE is a simple concept. It’s the amount of profit the company earns divided by the amount of shareholder equity. Let’s say you start a business with $100. Over the course of a year you earn $20 from this business. This means your return on equity is 20% ($20/$100).
The second element is retention rate. As the name suggests, retention rate is the amount of money you put back into the business. From the earlier example, you earned $20 at the end of the year. Let’s now say that you spent $10 and held decided to reinvest the remaining $10 into the business. That means your retention rate is 50% ($10/ $20).
With this information on hand, you can easily estimate the business’ growth rate over next year. You assume the business will earn the same return and you’ll reinvest the same ratio of money. Multiply the two elements and you have the sustainable growth rate.
In this example, your business’ sustainable growth rate is 10% (20% x 50%).
You can apply the same logic to figure out the growth rate of a listed company. Find the ROE and the retention rate (earnings minus dividend). Multiply the two and you have a reasonable estimate for ongoing growth.
Sustainable dividend growth may be the most logical way to estimate future growth, but it doesn’t apply to some companies. Some companies switch the retention rate frequently. Management decides to hold back more money sometimes and at other times it feels more generous. Some companies also have erratic returns on equity.
A sustainable dividend growth rate for such companies is hard to estimate, but not impossible.
Instead of looking at the fundamentals, you can use the company’s history to see how the dividends have grown. Look out over the past 5, 10, or 20 years. If you can spot a pattern of regular and consistent growth, you can safely assume the growth rate will hold up over the future.
The Dividends Aristocrats Index, which we discussed last month, is based on this principle. Stocks that have managed to pay a growing dividend over the past 25 years are selected to form the index. These stocks are more likely to keep growing at the same rate in the future. That’s what makes them great income picks for dividend seeking investors.
Compare with other firms
There’s two clear options for estimating dividend growth – sustainable rate or historical trends. But what if the company you’ve picked has never paid a dividend? If the company has never declared a dividend, it’s nearly impossible to estimate the retention rate, the payout ratio, or the historical trends of dividends.
A lot of well-known companies fall into this category of non-dividend payers, including household names like Google and Amazon.
The best way around this is to compare the dividend rates of similar listed companies to figure out an average dividend rate for the industry. So, if you take Google as an example you can simply use the dividend rate paid by other mega tech companies such as Apple, Microsoft, and IBM. The dividend yields for these publicly-traded companies is 1.7%, 2.4%, and 3.4% respectively. The average of those three is 2.5%, whereas the average dividend yield on the S&P 500 is 2.2% and the dividend yield of S&P North American Technology Sector Index is 0.83%.
Based on this information you can safely assume that Google would pay a dividend somewhere between 0.8% and 2.5% if it ever declared one. Of course, you would also need to estimate future earnings to pin down the rate.
Dividend growth is a key part of any stock valuation. The clearer the estimate the more accurate your valuation is likely to be. The most logical way to estimate future dividends is to use the sustainable rate of dividend growth. However, for companies that either pay erratic dividends to none at all, you may need to estimate the dividends based on historical trends or industry analysis.