Tuesday, April 21, 2015

Dividend Growth Stocks Increase Intrinsic Value Over Time

Dividend growth stocks get no respect. These slow and steady companies tend to produce results for long-term investors, who plan on holding for at least 10 - 20 years. Unfortunately today, the average investor has a much shorter time-frame in mind ( which probably explains why so many fail and never use the stock market for its true potential as a powerful wealth generator for retirement)

Dividend growth stocks are quiet compounding machines, that satisfy customer demands, constantly improve their operations, adapt their offerings to the changing consumer demands, while also innovating and growing their market share in their respective industries.

Over time, those companies manage to increase sales, earnings and dividends, which make them more valuable. This increases their intrinsic value to investors, who generate a rising inflation adjusted stream of income through dividends, and unrealized capital gains to those who are patient enough to sit and wait. Thus those investors end up having their cake and eating it too.

I always talk how I never want to pay more than 20 times earnings even for the best quality dividend growth stock. However, I am willing to hold on to a company I own, even if it sells for 30 times earnings today. This is because I have a long-term mindset when it comes to holding stocks. I know that a company that sells for 30 times earnings today, but manages to grow earnings by 8% – 9% per year for the next 20 years will be able to deliver satisfactory returns for my capital.

This is the reason why my upper limit is always 20 times earnings, and not something like $100/share  entry price target ( from a company with $5 in EPS). A quality dividend growth company with $5/share this year, will probably earn much more than that in year two, a higher amount in year three etc. As a result, intrinsic value will be higher, since the business will be generating much more profit, and have the capacity to shower shareholders with a higher amount of cash dividends. Let’s say that EPS grows by 7%/year, and the stock pays a 3% dividend yield. This mean that the intrinsic value will be $100 in year one, $107 in year 2, and $114.49 in year three. Therefore, sitting in cash and waiting for the perfect price might leave the market timing investor in the dust over time.

This could be best explained by looking at Johnson & Johnson (JNJ) shares since 2002. You can see that earnings per share increased from $2.16 in 2002 to $5.70 by 2014. At the same time the share price increased from $53.71 to $104.57. For the patient dividend investor, it made sense to buy the shares since 2005. It also made sense to patiently hold on to the shares, since earnings and dividends increased, which also propelled the intrinsic value higher.

The intrinsic value increased from $43.20 to $114. The intrinsic value is derived by essentially multiplying the annual earnings by a P/E of 20. This is a rough approximation using a limited data set, since I did not want to use too much numbers and assumptions in trying to make a point on intrinsic value.

You can see that the stock has been selling below 20 times earnings since 2005. An investor who bought and held essentially was rewarded with increasing intrinsic value over time, despite fluctuations in the share price. The dividend investor was able to ignore fluctuations in the share price because they were paid a higher dividend every single year. When a company you own increases dividends, you know that its intrinsic value is growing. However, you never know how long it would take for the stock market to recognize that increase in value. If you had to rely only on the judgment of the stock market, and had to sell stock to  live off in retirement, you could be in for a big trouble when stock prices are flat or down for extended periods of time. However, if you live off dividends, you do not have to worry about stock markets or price fluctuations. This is because a successful company that manages to earn more over time, will also send you cold hard cash every quarter. This means that you will not have to sell stock, and your ownership stake will not be reduced because of that. In addition, you will not have to speculate and bet your retirement on stock prices increasing every single year.

I believe for my investing that I should put money to work each month. Even if I end up paying high prices, which are not exceeded for 5 – 10 years, I won’t care, as long as the internal compounding is still going on, and there are reasons to believe it will continue. With this disciplined strategy, I might end up purchasing shares at multi-year highs. However, I would also have the discipline to keep purchasing shares of quality companies even when everyone is scared during the next bear market, recession or bank crisis. As you can see from the table above, buying at all time highs is not a problem, as long as someone does not overpay and as long as the business keeps growing. While buying at the depths of the bear market was very smart in hindsight, the investor does not really need to wait for a correction before initiating a position. If they choose the right business, its management will do the heavy lifting by compounding earnings, dividends and propel intrinsic values higher.

At the end of 2014, the shares were selling at $104.57/share and close to 18 times earnings. If someone wants to time the stock to a price of $91.20/share for 16 times earnings, they are taking a risk in lost opportunity cost. This is because if earnings keep going higher by 6%/year, the intrinsic value will increase in lock-step. Therefore, it gets less and less likely with the passing of each year that a price of $91 will be less likely to be seen again. Therefore, if you quibble over a few dollars or cents in share price, you are likely to miss out on the big moves that truly count. In the case of Johnson & Johnson, the big move is 5- 6% annual growth in earnings per share, coupled with a 3% - 3.50% annual dividends.

At the end of the day, if you believe that US will have a better and stronger economy in 30 years, a diversified portfolio of US businesses is the best bet on that prosperity for the average investor. In addition, if we were to get lower prices from here, I would be able to deploy any dividends I receive at much lower prices and valuations than today. I view that as a win-win for the long-term dividend investor. Actually, the best thing that could happen for someone who is just starting their investing journey is to start putting money to work during a period of depressed stock prices. This was the period between late 2008 to late 2012, when a lot of companies were selling for cheap prices, while everyone was waiting for a double-dip recession or hyperinflation.

Relevant Articles:

Mistakes of Omission Can Be Costlier than Mistakes of Commission
Opportunity Costs for Dividend Investors
Why would I not sell dividend stocks even after a 1000% gain?
Optimal Cash Allocation for Dividend Investors
Dividend Growth Stocks – The best kept secret on Wall Street

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