Valuing Dividend Stocks

Why Dividend Paying Companies Are Easier to Value and to Predict Future Share Price Than Growth Companies

One of the advantages of selecting high quality dividend paying stocks on which to employ Leveraged Investing strategies is that those stocks tend to be a lot easier to value.

The more confidence you have in a business's worth, the easier it becomes setting up suitable and conservative option trades and the lower risk those trades become.

This page explores some reasons why dividend paying stocks, I find, are easier to value and to work with.

Valuing Dividend Stocks - Stability in Earnings

When I reference dividend paying stocks, I'm generally talking about higher quality companies with a long track record of paying dividends and some level of fairly consistent dividend growth.

Well, no surprise here, but a company with those characteristics is probably going to be a lot less volatile than its non dividend paying, high growth peers (let alone its inconsistent growth peers).

Such a company is likely to be a more mature business with stable and predictable operations - and therefore a lot less likely to be wildly mispriced.

Valuing Dividend Stocks - Dividends as Price Support

The dividend of such a company also often acts as support against significant share price declines. Again, no surprise there - that's a pretty standard argument.

If the share price of a quality company that typically yields in the 3% range begins to decline, pushing the current dividend yield higher, at some point, new investors will likely step in to scoop up shares and lock in that higher dividend yield.

On the other hand, if that same stock which traditionally yields 3% is all of a sudden yielding 7-8% because of a big drop in the share price, that's a pretty good indication that something serious has happened to the stability of the underlying business's operations and earnings.

Valuing Dividend Stocks - Dividends as Frame of Reference

But I think that a company's dividend yield has another important function beyond acting as a price support mechanism - it also gives investors an important frame of reference.

Now, obviously, a company's dividend yield (which is not only determined by the amount of the dividend, but also by what investors are willing to pay for that dividend) will be affected by a number of factors. And those will be company specific as well as due to macro factors such as the overall inflationary and interest rate environment.

Still, having the ability to compare a company's current dividend yield to its historical yields, gives dividend stock investors an important metric that just isn't available to traditional growth stock investors.

Don't look for a specific formula here, but if you find a stock where the yield has noticeably changed from its historical range, it may be worth you while to ask why? Is there a rational reason (specific to the company or at a macro level) why investors are now paying more (or less) for the company?

Sometimes, due to technological, demographic, or social changes, a company's business model is no longer viable, and a long term permanet deterioration of the firm is the most likely outcome. If such a company pays a dividend, the yield on it could be enticingly high, in which case you'd do yourself a big favor by avoiding the temptation to invest.

But at other times, an elevated yield could be the result of a (former) world class business having temporarily lost its way, and the market not taking the long view as it relates to the company's turnaround efforts.

Providing there really is something to turn around (i.e. the company still has significant structural competive advantages that it's simply not capitalizing on), then one of the best times to invest in a great company is when that company is struggling.

The Difficulty in Valuing Growth Companies

In contrast to high quality dividend paying companies, high quality growth companies, I find, are more challenging to accurately value.

That's probably largely due to the unpredictability of earnings. It's not that earnings are necessarily erratic, but when a company is growing fast, it's not always easy to estimate that rate of growth.

Take, for instance, a successful company that's been growing its earnings 30-35% a year for a few years. But what happens when the company reaches a certain scale were those growth rates are no longer sustainable? What happens if they report earnings one quarter and the growth rate has slowed to 15%?

It may still be a high quality company, but chances are that its share price is going to get crushed as the market reprices the company in terms of that lowered growth rate.

And here are some more reasons why I prefer dividend growth investing over traditional growth investing.

What's the Point - Why Do We Even Care About Valuing a Company Anyway?

Why? is a very important question, and especially so when it comes to the issue of valuing companies.

There are a number or reasons why it's important that we get it right on valuation.

One powerful concept is that the less you pay for a business in terms of either its dividend or earnings yield, the higher the rate of all your future compounded returns.

And when it comes to option trading and Leveraged Investing, working with an overvalued stock, or one without a well-defined floor, can be disastrous.

Although the overall volatility (and available premium income) will be less with a high quality dividend growth company, the opportunity to consistently make profitable trades is greatly increased.

And the basis for Leveraged Investing is that your option trades don't need to be attempts to win the lottery - conservative option trades coupled with long term investments in the highest quality companies is a combination that, in my experience, produces powerful compounding results over the long term.

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