Stock Valuation Method for Dividend Stocks

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Jae Jun

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Stock Valuation of Dividend Stocks using the Stock Valuation Model

stock valuation dividend stocks

Stock Valuation Dividend Stocks

For current or interested users of the Old School Value Stock Valuation Models, today I look at how to use the valuation spreadsheets to guide you through analyzing dividend stocks, and what to look for. This is by no means a complete list, but it should cover a lot of the important grounds for dividend stocks.

Desired characteristics of dividend stocks are as follows:

  • Strong Franchise
  • Consistent and Predictable
  • Strong balance sheet so that dividends can easily be paid
  • Dividend payout
  • Dividend growth

Strong Franchise

The word franchise is used to define a company with a strong brand, a good business model and one that generates returns that exceeds its cost of capital.

Since you are looking for a dividend stock that can continue to pay shareholders, the business must have a moat. You are not looking for high flying growth stocks, but one that is well run and where growth may have has slowed down, but the company makes so much cash day in and day out that it has to pay it out.

Quick Check for Strong Franchise using EPV

A quick check to see whether the company has a strong franchise is to compare the EPV (Earnings Power Value) with the book value or net reproduction value.

Rather than get into the full details, the short version of it is that if EPV is greater than the net reproduction value, the company has a moat.

A company where EPV is equal to its reproduction value or less than the reproduction value is a company that destroys value and cannot sustain its business in the face of competition.

Go to the EPV worksheet and take a look at the EPV graph. The graph below is what you want to see.

Consistency and Predictable

When looking at which dividend stocks to buy, you want to buy the dividend stock that has consistent and predictable margins.

This is also true for the balance sheet and cash flow statement.

A company with a consistent balance sheet will ensure that financial risk of collapse does not occur, and likewise for the cash flow statement, steady growth in cash from operations and free cash flow or owner earnings are all good signs to look out for.

There are a few ways to check for consistency and predictability with the Stock Valuation Models.

Check Consistency and Predictability with Katsenelson Absolute PE

First go to the Katsenelson Absolute PE section and then look at “Determine Earnings Predictability”.

Note how gross margin, net margin, earnings and cash from operations has been trending.

In the case of Microsoft, numbers have been inconsistent over the past 5 years which is Microsoft’s weakest point.

You don’t have to end the check here. You can also go to the financial statements and check whether the company is free cash flow positive and whether it has been increasing.

Strong Balance Sheet so that Dividends Can Easily be Paid

Checking the balance sheet will let you know how healthy the company is. What you don’t want is a dividend stock that is heavily loaded with debt and paying dividends at the same time. Sure, many companies carry a certain debt load, but there are some companies where they continue to pay dividends by issuing debt, just to prevent disappointing investors and to support the stock price.

You can ensure this doesn’t happen by analyzing the balance sheet ratios.

Go to the Ratios section and view the Solvency and Capital Structure Ratios.

This will give you a very good picture of the company debt structure.

Dividend Payout

The dividend payout ratio is different to dividend yield in that it looks to see how well earnings support the dividend payment. If the ratio is low, it means that the dividend is easily covered by earnings and the company should not issue debt to pay dividends.

A point to note is that mature companies tend to have a higher payout ratio because it will distribute more of its cash, while growing or smaller companies will have a small payout ratio because it will use the cash to fuel further growth.

The formula for the Dividend Payout Ratio is

Dividend Payout Ratio= Dividend  / Net Income

The dividend payout ratio can also be adjusted to use free cash flow instead of net income.

Dividend Payout Ratio= Dividend  / Free Cash Flow

The payout ratio can be easily calculated by going to the EPS section of the income statement where EPS and dividends per share are located.

Dividend Growth

I’ve left the most obvious part for last for any dividend stock, and that is dividend growth.

To continually generate income from your portfolio, you need to find companies that will increase their dividend each year. There are many companies that issue a high yielding dividend, but then the problem becomes the dividend staying at the same level despite growth in earnings and cash.

In order to determine whether a company will continue to increase the dividend, you look to see what the growth is for net income and free cash flow.

Net income peaked in 2011 and 2012 along with TTM numbers show a decline, but this has not translated into a reduction in free cash flow as seen below.

It would be safe to assume that Microsoft will increase its dividend in the following year as well.

dividend stock analysis msft

Do Not Forget Valuation

Lastly, with any company, don’t forget valuation. Since safety seeking investors flock to buying dividend companies, there is a risk that you may be paying too much of a premium.

Lately, there have been claims that dividend stocks are becoming a bubble because people have been rushing to buy dividend stocks to avoid 0% interest in their banks and the danger of bonds in a low interest rate environment.

Whatever the case may be, make sure the company is cheap or fairly valued by using the several valuation models contained in the spreadsheet.

For stable, mature stocks however, I have found just using DCF to be quite satisfactory as the inputs required for the DCF model is best suited for such companies.

Lastly, if buying dividend paying stocks is your cup of tea, this website has organized each dividend stock by industry.

Disclaimer

This analysis is based on the current spreadsheet as of Nov 2012. Future versions may be different with additional features or changes in layout. The spreadsheet is subject to change.

About Jae Jun


Jae Jun is the founder of Old School Value. He is on a mission to provide practical and actionable value investing tools, tutorials and educational material to help empower the individual investor. Keep in touch with Jae via any of the methods linked below.

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  • shamapant

    Just be careful w/ the EPV part. When EPV is so far above Asset Reproduction, it was supposed to imply danger, not safety, because you had to qualitatively judge the sustainability of the franchise, and it implied that if the franchise wasn’t sustainable, you were due for a large stock price drop.

  • Collin

    $100m spent on share buyback have the same effect as $100m in dividends, assuming same tax rate. As such, when looking at dividend companies, you should treat share buyback as part of dividends (minus issued shares). Beware of companies that are increasing dividends while decreasing share buybacks because the net effect is the same as the previous year

  • http://www.oldschoolvalue.com/ Old School Value

    good point. Comes down to a case by case basis, but so far, I’ve found that the EPV has done well in determining the moat of the business. Mostly bigger well known companies have shown this type of EPV level.

  • http://www.oldschoolvalue.com/ Old School Value

    but the reason that people buy dividends is for income, so share buybacks, while it may act like dividends, is not something that dividend investors are particularly interested in.

    If the company also buys backs shares at cheap prices as well as distributes dividends, it’s even better though.

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