Assuming you have your dividend shopping list in hand, and you have worked out when and what you want to buy, the next step is to determine a “fair price” to buy. For new, and even experienced investors this can be the most difficult part of building a Dividend income stream.
I don’t believe that you need to get too hung up on debating the right buy price. In fact, if you have a long term view of holding a stock, increases in the stock’s value over time will actually reduce the financial consequences of buying at a premium to fair value.
What is fair value?
When I first started investing, I used to be obsessive about ensuring that I bought under “fair value” with a considerable margin of safety. As I’ve had more experience with investing, I’ve been more relaxed about this.
Fair value is the idea there is one “magic number” that a stock is worth. If you buy the stock at that “fair value” price, you are getting a set of future cash flows from that business that represent a fair price for what you paid for them.
Pay above the fair value price and you getting less for your money than what you should, but pay below the fair value price and you are getting a bargain. Ever heard the Warren Buffet expression of buying $1 for 50c? That’s exactly what he means.
The problem is that there is no exact fair value for a stock. Its all implicitly based on a range of assumptions of the future growth and revenue for a business. If you ask 10 brokers for what their fair values are for a stock you will get 10 different answers. I’ve never been terribly fixated on doing fair value or net present value calculations for any stock that I buy.
I don’t believe that my relative advantage is building detailed valuation models based on a variety of assumptions, which are all uncertain. There are enough people who make very good money doing exactly that and updating these valuations quarter after quarter.
My advantage and your advantage is that we can afford to hold great businesses for many years. We are buying businesses for the tangible yield that they are giving us today, the growth that they will provide us into the future and the fact that they have paid increasing dividends for years.
In this situation, the key is that you haven’t sacrificed an opportunity to buy something which could have yielded more, with a similar level of risk. This is something that you can assess based on relative yields and where the yield of a particular stock fits in relation to other stocks.
In any case, there are a few valuation techniques that you can apply to determine just how “fair” or how good a buy you are getting.
Net Present Value
As I mentioned, there is a commonly accepted valuation method called the NPV or Net Present Value that essentially takes the sum of all of the future expected cash flows of a business and discounts them back to determine what you should be prepared to pay for that set of cash flows. Its inherently variable, and you won’t get any 2 forecasts that yield you the same answer, because estimating a future business’s performance is inherently uncertain.
Having said that most brokers produce an NPV or fair value for a stock and accompanying Buy or Sell ratings which you can easily get through the brokerage service you use. Morningstar.com also produces valuations for all the stocks that it covers which are freely available on its website.
Relative Fair Value
I find the notion of relative fair value far more useful for my own purposes. This is the idea of looking at how a stock trades currently, versus either how it’s traded in the past, or how it trades with its competitors and the general market. All these valuation techniques are fairly easy to apply and all help to give a sense for over or under valuation.
Fair value based on stocks’s history
For stocks that are mature and have a fairly long history of dividends, I have become comfortable with looking at something that I think of as “market based fair value”. This is nothing more than working out a stock’s average historical dividend yield over a long period of time. Purchases that give you a lower yield than the historical average are above fair value, and prices that give a higher yield than are below fair value.
As an example, if Coca Cola’s average dividend yield is 2.5% over a long period of time, buying Coca Cola stock at a price which gives you a dividend yield of say, 1.5% could mean that you are buying above fair value and paying too much. On the other hand, buying Coca Cola stock at a price which gives you a dividend yield of 3% probably means that you are buying under fair value, and getting a good deal.
While not a full valuation it’s quick, simple and fairly effective. You need to do a quick check to make sure that there haven’t been material changes in the stock’s business that have changed its risk/return profile. I then triangulate this with an independent view on valuation that I get from Morningstar to see whether I am on track in terms of whether a stock is over or undervalued.
Fair Value based on a stock’s competitors
You can also look at a stock’s valuation versus its competitors to see if it may represent good value. Here the PE or Price/Earnings ratio tends to be fairly valuable. It’s something that you can look up pretty easily on yahoo finance or Morningstar.com.
For example, BP trades at a PE of close to 6x earnings. This is close to the cheapest that it has been trading at for most of the last 10 years, as it has generally averaged closer to 10x earnings. In fact, BP is cheaper on most measures including Price/Book and Price/Sales than its been at any time over the last 5 years.
I would then compare BP’s PE to the PE ratio of oil majors as a whole to see if they are being discounted as a group. Interestingly, Exxon, Chevron and Royal Dutch Shell all trade between 8-10x earnings. Clearly there is a big discount built into the BP stock price currently, and this can suggest some undervaluation of BP.
Does buying a stock create opportunity cost?
The last thing to assess when adding a dividend stock to your portfolio in my opinion is whether you would lose an opportunity relative to buying another dividend stock with similar yield. This is a very subjective assessment based on earnings quality and risk, not to mention any other objectives that one has in putting their dividend machine together.
While there may be other companies in the market today that may be offering higher current yields they may not have the long term dividend history or earnings quality of a specific stock.
The challenge for an investor is to not dilute the quality of their dividend businesses by substituting a high quality earning and dividend stream with an inferior one.
For example, buying a Hidden Gem, which is offering the same dividend yield and dividend growth as a Classic Dividend payer may represent an opportunity cost, given you could buy a similar income opportunity with less risk.
So buying a company that has 2 years of dividend history versus something like Coca Cola, may not be the most sensible move if both have the same initial yield, unless you could determine that the Hidden Gem payer was likely to have much better dividend growth than Coca Cola going forward.
In my view, buying as close to fair value as you can is certainly pretty valuable. However this is more to ensure that you aren’t sacrificing an opportunity to make a more compelling dividend investment in another company that represents better yield or stronger growth.
To help ensure that there is no opportunity cost, its not necessary to develop detailed valuation models for a stock that you look to invest in. This takes lots of time, and there are no guarantees that you’ll get it right, because the future is inherently uncertain.
However starting with some basic valuation measures such as how a stock trades in relation to how its traded in the past, or trades vs its competitors can help give you an idea of an opportunity looks in the general context of the market. Overlaying this with a quick scan of other dividend opportunities that exist can help give a sense for whether there is any opportunity cost.
Of course, the most subjective element of this is to try and assess how good another opportunity may be and just how good relative earnings quality is. All else being equal, I always go for the stock with the longer track record if initial yield and expected growth are otherwise the same, however this rarely is the case, and there’s a need to make some trade offs.
Once the basic valuation due diligence is done, I’m happy to let an investment in time do its work. Letting long term earnings quality and dividend growth come to the fore will stand you in much better stead that doing a detailed valuation model which will most likely end up being inaccurate anyway.