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


  1. DGI,
    Some others use a different norm, if you will, for the price-to-earning ratio. Fastgraphs, for example, uses a P/E of 15 for most stocks. I know that the low interest rate environment makes a higher P/E normal, at least while interest rates are low. So, my question is this: do you adjust your upper P/E limit as interest rates move up and down? I seem to remember you using a P/E of 15 in the past.

  2. Hi Keith,

    Please check this article on why I do what I do:


    Best Regards,

    Dividend Growth Investor

  3. DGI,

    This post highlights two very important points for me:
    1) I recently undertook an analysis to try and figure a "portfolio value" that will get me to my dividend crossover point. The fact is, a portfolio value is not a good surrogate for dividend income, because stock prices can be volatile and a lot will happen between the "beginning" of the investing journey and that point. What's more important is lock-step growth (unless a company has a small payout ratio and is looking to distribute more to its shareholders) in three semi-independent factors: share price, EPS, and dividend per share. The metrics that we commonly use are ratios of these factors (yield, payout ratio, P/E ratio). An imbalance of growth the growth rate between these factors leads to trouble (over inflated price, too much EPS w/ not enough being returned to shareholders, or unsustainable dividend growth). As a result of this, I've found it very hard to model exactly how much I will need to contribute over the years to reach my dividend crossover point. But, while I can't know what exactly I will need to have invested to reach that point, I see how important sticking to the strategy is (as per your JNJ example above) in order to have a chance of succeeding at it. I wager that the ideal scenario is, in the long term, having securities that grow (at a rate greater than inflation) the share price, EPS and dividend annually at a roughly equal pace. Well, more ideal would be EPS and dividends growing with no share price appreciation, but that is not likely to happen:)
    2) Blindly re-investing dividend proceeds is probably not the smartest general practice unless you know that EPS, share price, and the dividend are all growing at about the same rate. I know you know this already. However, I had to use some modeling to convince myself of the impact. Assume you had a100 shares in a security that was $40 per share, had $1 dividend annually (for simplicity), and $2 EPS. That gives you a P/E of 20, payout ratio of 50% and a yield of 2.5%. If all of those metrics increased at 5% annually, and you reinvested at the the "appreciated" share price, your dividend payment at 10 years would be $206.10. And, at year 10 your P/E, payout ratio, and yield are still the same. If the share price increases by 10% annually, but EPS and dividend increase at 5% only, your dividend payment at 10 years would be $195.85. And, at year 10 your P/E ratio would be 31.85, payout ratio would still be 50% and your yield would have dropped to 1.57%. Now, you might say, "but now the value of your portfolio is $12,669 with the share price appreciation, vs $8450 without the appreciation...so how does a loss of only $11 dollars per year in dividends matter when you now have ~$4200 more than you would in that other scenario?" That's because that extra capital is subjected to the swings of the market. If the share price in this security dropped to $71 per share (~28% drop...NOT unheard of), the portfolio values are the same. And that capital advantage has been wiped away. You now rely on your ability to time the market very well, which many argue, is unlikely for sustained periods of time.

    Anyway, this article put some things in perspective for me, so I thought I would share - STICK TO THE STRATEGY!


    1. Salvatore,

      Thank you for reading and leaving a very thoughtful comment. Thoughtful comments always make me happy, since I get to connect to smart readers in the process of interacting.

      1) It is very important to stick to a strategy for a long period of time. Sticking to a strategy when it produces great results is easy; actually having the conviction to stick to a strategy when it is temporarily in the doldrums is what separates investors who make money from those who don’t make money. Investors who frequently switch strategies never do as well as they should. As you have noticed, modeling/simulation is extremely difficult, because the real world does not conform to linear patterns of behavior. However, I believe it is “easier” to estimate dividend income given a certain conservative estimate for dividend growth and yield and a certain rate of investments per month, than to estimate the value of that portfolio. By “easy” I mean that the estimate is more likely to be closer to the actuals because dividends are more stable and reliable than capital gains.

      2) Over the long run a company that grow earnings, can grow dividends, and its share price should rise. However, share prices are also dependent on valuations. This is where using a model breaks down – a company with earnings doing the right thing could get overbid by investors to sky-high P/E ratios if it is “fashionable” or it could be avoided by investors even at single digit P/E ratios if it is viewed as “doomed”. When you buy at a cheap valuation, your dividends accelerate your return due to reinvestment at low values. If you reinvest at a high valuation, your dividends increase returns but not by much. In reality, a company that grows only because valuation multiple expands is likely subject to too much speculation. What happens if everyone loses their rose-colored glasses, and the share price contracts? In 1999 – 2000, investors had overbid indexes like the S&P 500 to something like 30 – 35 times earnings. As a result, despite growth in revenues, earnings and dividends, the total return was close to zero for the next 12 years or so. Those who sold off index shares following the 4% rule to live in retirement likely “spent” half of their assets and could run out of money if markets do not increase by 8-10%/year every year.

      You might like this article: http://www.dividendgrowthinvestor.com/2015/02/buying-quality-companies-at-reasonable.html


Questions or comments? You can reach out to me at my website address name at gmail dot com.

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