Monday, January 11, 2010

Valuing Dividend Stocks

Few investors these days seem to grasp the idea that stocks represent fractional ownership of real businesses. This is especially difficult to understand as electronic trading has become widespread, and it is now possible to buy and sell stocks and derivatives on these equities within seconds from the comfort of your home. While as a dividend investor I typically look for stocks with a consistent stream of earnings, which translates into a long history of dividend growth, I am always on the lookout to learn something new as well.

While earnings power is essential, it is also important to understand that a business or its assets do have some value, whether as a whole or as a sum of its parts. Most of the times when there is a merger or an acquisition of a company, investors get a price for their holdings from the acquirer. Thus they are able to monetize their partial ownership rights, and their stocks rise in value in the process. Other times the market undervalues companies which hold on for too long to liquid assets, because of the fear that excess cash in the hands of management might not lead to improved financial condition over the long term.

One such company was Magic Software Enterprises Ltd. (MGIC). Magic Software Enterprises Ltd. is an Israeli company which develops, markets, and supports software development and deployment technology and applications. Back in December the company announced that its board of directors has declared a cash dividend in the amount of US$0.50 per share and in the aggregate amount of approximately US$16.0 million. The stock increased in value from $1.87 to $2.23/share after the announcement. The stock is already trading ex-dividend however, which means that investors who purchase the stock today would not be able to receive the special distribution.

At the end of the third quarter of 2009, Magic Software held cash and cash equivalents worth $36.85 million and had total liabilities worth $14.21 million. This was worth approximately 55 cents/share, and that’s without including any of the company’s receivables, fixed assets, intangible assets and the company’s ability to generate future earnings. In addition to that the company has been profitable in 2007 and 2008 and is on schedule to earn money in 2009. What might have triggered the need for special dividend was the sale of the company’s office building for $5.20 million in cash in early December 2009.

At the end of the day it is important to understand that stocks represent fractional ownership of real tangible businesses. An important component of success in investing is also finding the best opportunities at bargain prices as well in addition to diversification and dividend reinvestment. Thus I believe that even if we have another lost decade, there would be plenty of opportunities for investors to make money and for companies to unlock their intrinsic value through dividend raises or special dividends.

Some of the companies which have been able to create consistent value for shareholders over the past few decades include Automatic Data Processing (ADP) and Emerson Electric (EMR). Both stocks currently trade at attractive levels and have well-covered dividends.

Automatic Data Processing, Inc. (ADP) provides technology-based outsourcing solutions to employers, and vehicle retailers and manufacturers. It operates in three segments: Employer Services, Professional Employer Organization Services, and Dealer Services. This dividend aristocrat has raised dividends for 35 years in a row. The stock is trading at 16 times earnings and yields a comfortable 3.20%. The company has a ten year average dividend growth rate of 14.50% per year. Last year ADP raised distributions by only 3%. When the business recovers however, the company would be able to grow distributions in the low double digits. The book value of the assets is $11.23/share.(analysis)

Emerson Electric Co., (EMR) a diversified global technology company, engages in designing and supplying product technology, as well as delivering engineering services and solutions to various industrial, commercial, and consumer markets worldwide. This dividend aristocrat has boosted distributions for 53 consecutive years. The stock is trading at 19 times earnings and yields 3.10%. The company has a ten year average dividend growth rate of 6.50% per year. When the world economy recovers, the company’s diversified business operations should be able to support a dividend growth in the high single digits. The books value of the assets is $11.33/share.(analysis)

Full Disclosure: Long ADP and EMR

Relevant Articles:

- Special Dividends Unlock Hidden Value in Stocks
- Why dividends matter?
- What Dividend Growth Investing is all about?
- 3 dividend increases, more expected in January

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