Stock Valuation Method for Dividend Stocks
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Stock Valuation of Dividend Stocks using the Stock Valuation Model
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
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.
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.
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.
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.
This analysis is based on the OSV Spreadsheet which is available as a download for all Old School Value members.