Wednesday, February 22, 2012

Does entry price matter to dividend investors?

The reason for the lost decade in stocks is that many otherwise quality companies were overvalued in the early 2000s. For example Johnson & Johnson (JNJ) was trading at 29.30 times earnings in early 2000, whereas McDonald’s (MCD) traded at 26.90 times earnings. Even some of the best dividend stocks are not worth paying more than 20 times forward earnings.

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

Relevant Articles:

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


  1. Do you have an opinion or analysis on Waste Management (WM)?


  2. Another excellent post from one of my favorite blogs. I have not been able to completely figure out my stragegy on this issue. On stocks like the cited JNJ & MCD which increase dividends in double digits every year, there is cerainly an opportunity lost if you do not invest - even at high valuation levels. And stocks like JNJ do not tend to have large price swings. Any advice or rule of thumb guidance on when it is smart to go ahead and invest for rising income versus waiting on a 10 or 20 percent drop, which may cause you to miss year of dividends and increases? Any advice or sources from the author or other readers would be greatly appreciated. Thanks - Cory

  3. Too bad Obama is going to war on dividends. His latest budget calls for tripling the taxes on dividends.

    As a result: companies will lower dividend rates, some will stop them because they will be so tax inefficient; investors and retirees will see their incomes drop and may speculate rather than get killed with 43.8% tax on dividends.

    I've finally got an incredible dividend portfolio and the amateur in the White House is going to kill all my work!

  4. I think it matters for a few reasons. A novice dividend investor does need to learn from some experience of when to buy and value always adds a benefit when you can get a deal in the short-term. That being said....don't nickel & dime a dividend!

  5. Even if Obama raises the top dividend tax rate to 44% plus, and companies quit paying dividends, the money will then be used for share repurchases or reinvested into the company. So instead of dividend payouts, companies could trade at higher valuations.

  6. Excellent article.

    Does P/E really signify an appropriate entry as opposed to Graham number at one extreme? Really just thinking out loud. Again, great article.

  7. The matter of rising taxes on dividends is far from law. The proposal raises taxes on those making more than $250k so that exempts many. Also, retirement accounts would not be taxed, so securities there would be spared. This country needs to spend less and increase revenue itself, so we should expect some compromise and not continued lower taxes. At this point I'm personally paying a lower tax rate on income than on dividends due to current law. A move to tax dividends like regular income would result in a lower tax rate for me personally, since dividends are taxed at 15%.


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