Investors who purchase shares in companies trading at high valuations will be stuck with a low yielding security for a long period of time. In addition, companies whose share prices spot high valuations tend to be more volatile. One lousy quarter where earnings per share missed estimates by one penny could bring in lower prices for a long period of time. On the other hand, a company which is attractively valued, cannot go much lower because the company would be trading below what it might be worth to an acquirer. In addition, a company with a P/E below 20, which has a payout ratio of 50%, can easily afford to have a current yield of 2.50%. A company with a P/E of 50, with a 50% payout ratio will probably only yield 1%.
The issue with high multiple stocks is that future growth is already accounted for in the stock price. This means that long-term investors could likely see little in gains even if earnings grow over time. Companies cannot realistically grow above 20% per year for extended periods of time. Once growth slows down, the P/E ratio will contract, and the price would either go down or stay flat if earnings have increased sufficiently in order to compensate for the lower multiple.
On the other hand companies which are trading at low multiples today are attractive candidates for several reasons. First, a company with a low multiple that pays out one third to one half of its earnings as distributions could offer a very sizeable current yield. For example, chipmaker Intel (INTC) has a P/E of 10, a payout ratio of 35% but yields 3.20%.
Second, companies with low multiples that grow earnings per share will be able to offer high dividend growth coupled with above average current yields. This could lead to high yields on cost to investors who were shrewd enough to recognize the opportunity. The rising dividend payment would provide buy and hold investors with a rising return on investment. They would essentially get paid higher amounts each year, simply for holding their stock.
Third, as the dividend stream increases, value investors are going to recognize the value the company offers and would try to bid up prices. Even acquirers might decide to purchase these cash rich businesses, which would increase the price for the target.
Some quality dividend stocks, which are trading at low P/E ratios include:
Archer Daniels Midland (ADM) trades at a P/E of 13.80 and yields 2.20%. The company has raised dividends for 36 years in a row. (analysis)
Aflac (AFL) trades at a P/E of 11.50 and yields 2.70%. The company has raised dividends for 29 years in a row. (analysis)
Target (TGT) trades at a P/E of 12.30 and yields 2.30%. The company has raised dividends for 44 years in a row. (analysis)
Wal-Mart Stores (WMT) trades at a P/E of 13.20 and yields 2.30%. The company has raised dividends for 37 years in a row. (analysis)
Intel (INTC) trades at a P/E of 11.50 and yields 3.10%. The company has raised dividends for 8 years in a row. (analysis)
Chevron (CVX) trades at a P/E of 7.90 and yields 3%. The company has raised dividends for 24 years in a row. (analysis)
Medtronic (MDT) trades at a P/E of 12.60 and yields 2.40%. The company has raised dividends for 34 years in a row. (analysis)
Full disclosure: Long all companies except INTC and TGT
This article was featured on Carnival of Personal Finance #350: The Little Prince’s Journey to Financial Enlightenment and Carnival of Wealth, Nice Guy Edition