I’ve had some time to think about how we evaluate dividend stocks. First we’ll make some assumptions.
A healthy dividend paying company should have a payout ratio that does not exceed 60%. Which means annual dividends should not be more than 0.6 times the company’s earnings per share. According to common belief, the lower the payout ratio, the greater the potential for dividend growth.
Traditionally, if a company’s PE ratio is greater than 20, it is considered to be overvalued. So a company priced at 20 times EPS is accurately valued.
This last assumption is not up for debate since it’s just straight math. Yield percentage is equal to the annual dividends per share divided by share price.
So an average healthy dividend stock will pay a dividend of 0.6 times EPS and be priced at 20 times EPS. This works out to an average dividend yield of 3% (0.6/20). Which means for a stock to have a better yield, it either needs to be undervalued so the PE ratio is lower than 20, or have a higher payout ratio, which is not considered healthy. This is why finding bargains is so essential to dividend investors.
If you own nothing but healthy dividend stocks, the yields are all going to be roughly the same if the company’s are healthy. So what sets apart the big winners? Growth
As dividend investors, we typically search for companies with a solid history of dividend growth dating back 10 years or more, such as Dividend Achiever. The trailing dividend growth rate shows that the company will reward shareholders. But if the dividends per share were a function of the EPS, the ability to grow that EPS would be a stronger indicator of future dividend growth.
A company can most effectively grow its earnings potential through either innovation or expansion. By this, I mean releasing newer better products, building new storefronts, or selling in different markets. If a company has a lower payout ratio, it’s safe to assume it has more revenue with which to reinvest in these areas, thus growing EPS.
This is why most naysayers of dividend investing believe the strategy to be foolish, since mathematically, everything comes back to EPS. However, there is must to be said for a company that is able to payout a solid dividend yield and still grow revenue each year.
In a market where everyone with a paycheck has the potential to be an active trader, stock prices tend to auto-correct themselves for minor mistakes in valuation. For instance, if a company is overvalued by 5%, it is likely that after a month, it will be corrected at some point to its average EPS multiple. So, the only way to take advantage of massive dips in price is when a company has fallen on hard times due to a lawsuit or a bad quarter, but has the branding and strength to recover as a business. If the company looks statistically bad in the short term, but has the capability to recover and come back stronger, there is some serious growth potential there.
The company that comes to mind for me right now is Target (TGT). They have faced difficulties with their expansion into Canada as well as the recent security issues. As a result, the price has dropped over 17% from the 52 week high in July, 2013. TGT currently has a payout ratio of 46% and a PE ratio of 16.30. This results in a dividend yield of 2.83%. This is all based on an EPS of $3.73, which is almost 20% lower than 1 year ago.
Considering the PE ratio of Target was about 13-14 a year ago, I believe Target still has a little a little further to fall (probably mid-50’s). After that, the company has the brand and leadership to recover rapidly and return some substantial rewards to investors. I currently have a small position in Target (16 shares), and am looking to possibly double that, but I think it can wait another month to get a really attractive entry price.
I should also mention that Target has been growing its dividend for 46 years, making it just 4 years away from being a Dividend King. It’s dividend growth rate has been outstanding over the past 10 years, averaging over 20% annual growth. If you invested $1000 in this stock 10 years ago and reinvested all dividends, you would now have about 35.00 shares worth $2126.60 paying out $55.30 dividends each year. This is a little less impressive than Clorox, so that makes my decision even tougher.
What are your thoughts on Target?