Dividend Investors Should Focus on Valuation, not just Dividend Yield

Late in 2012, I was expecting that the stock market would decrease, because of the Fiscal Cliff hurdles. Unfortunately, I was not correct and the stocks market is trading close to all-time highs. Because of this bullishness in the markets, many quality dividend stocks are very close to being at the very high end of my acceptable valuation targets. While I usually try to avoid companies trading above 20 times earnings, when a stock trades above a P/E of 17, I might simply avoid it and purchase something cheaper. The more experience I get as a dividend investor, the more I realize that attractive valuation in terms of a low P/E is very important. Another equally important factor is to focus on companies which have the plan and business model that would allow them to grow earnings per share over time. Only after these characteristics are met, would I even look at the dividend metrics of a stock.

As a result, at times when I have seen a promising dividend growth stock trading at an attractive valuation in terms of low P/E, coupled with earnings growth potential, I have taken a small position, even if the entry yields were anywhere between 1.50% - 2%. This is lower than my entry yield of 2.50% that I usually tend to follow pretty strictly. I have usually made these investments with half the typical lot size that I make purchases with. For example, if I typically purchased stocks in $2,000 increments, a reduced lot size would be somewhere in the vicinity of $1,000/trade. In all of the situations where I have made these investments, I have made money and enjoyed double-digit dividend growth rates. These companies do not represent more than 10% of my portfolio, but contribute to a large portion of its overall growth. While most income investors tend to focus exclusively on yield because they need as much income as possible to pay for their retirements, I find this misunderstood niche of quality low yield/high growth dividend stocks to be quite appealing. I believe that every dividend investor needs to allocate a percentage of their portfolio in such high dividend growth stocks, regardless of their current yield, as long as the P/E ratio is not over 20.

In the current world of dividend investing, where everyone is following Johnson & Johnson (JNJ), Procter & Gamble (PG), McDonald's (MCD), I think that it would pay off big dividends over time if one focused on companies outside of the typical income investor’s radar. If you look at the above-mentioned dividend stocks in the 1980’s or 1990’s, which are widely held today, you would notice that they had low yields and high dividend growth rates. If one had been able to purchase them at attractive valuations, they would have made a very sizable future dividend income stream for themselves.

For example, the following stocks are trading at very attractive valuations right now, but are being ignored by income investors, simply because they do not yield above a certain arbitrarily chosen yield. With the market yielding close to 2%, and 10 year Treasuries yielding slightly less than that, the yields on these dividend growth dynamos do not look so bad after all:

YUM! Brands, Inc. (YUM), together with its subsidiaries, operates quick service restaurants in the United States and internationally. The stock is trading at 19.40 times earnings and yields 2.10%. This dividend stock has rewarded shareholders with dividend increases for 9 years in a row. Analysts expect the company to grow earnings by 12.07%/year over the next five years. Check my analysis of Yum!.

Wal-Mart Stores, Inc. (WMT) operates retail stores in various formats worldwide. The stock is trading at 14.50 times earnings and yields 2.70%. This dividend champion has rewarded shareholders with dividend increases for 39 years in a row. Analysts expect the company to grow earnings by 8.83%/year over the next five years. Check my analysis of Wal-Mart.

International Business Machines Corporation (IBM) provides information technology (IT) products and services worldwide. The stock is trading at 14.40 times earnings and yields 1.70%. This dividend achiever has rewarded shareholders with dividend increases for 17 years in a row. Analysts expect the company to grow earnings by 9.86%/year over the next five years. Check my analysis of IBM.

Family Dollar Stores, Inc. (FDO) operates a chain of self-service retail discount stores primarily for low- and middle-income consumers in the United States. The stock is trading at 15.80 times earnings and yields 1.50%. This dividend champion has rewarded shareholders with dividend increases for 36 years in a row. The company is expected to grow earnings by 12.86%/year over the next five years.Check my analysis of Family Dollar.

Such stocks represent great opportunities for young investors as well, who can afford to compound the small initial yields into double digit yields on cost by their retirement date.

Full Disclosure: Long FDO, YUM, WMT

Relevant Articles:

- Why I am not worried about the Fiscal Cliff and Dividend Tax Increases
- Most Widely Held Dividend Growth Stocks
- The World’s Best Dividend Portfolio
- YUM! Brands (YUM) Dividend Stock Analysis