How important is fair value for a dividend investor?

This is a topic that has been on my mind for some period of time. 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. Its time to explore what impact this has on dividend outcomes

 

What is fair value ?

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.

Market based fair value

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 stocks average  historical dividend yield. Purchases that give you a lower yield than the historical average are above fair value, and prices that give a higher yield are below fair value.

Its not how I would typically do a full valuation, but its quick, simple and fairly effective. This assumes that there hasn’t been any material changes in the stocks business that has changed its risk/return profile. I then triangulate this with an independent view that I get from Morningstar to see whether I am on track.

Does fair value matter?

Putting aside for a moment the question of how you get to a “fair value”, what are the consequences of buying above or below fair value and how does that impact you as a dividend investor. I’m going to use something called Yield on Cost which is my nominal dividend return is to my cost base. This measure has some limitations, but its pretty easy to understand. I’ll also look at stock payback period.

Let’s look at an example.

Base Case

We determine fair value for a GFI stock as $100. GFI stock pays us a $3.00 dividend, so our fair value dividend return is 3%. This stock increases its dividend annually by 10%. I’m a long term investor and I’ll be holding the stock for 30+ years, so my dividend stream looks something like this.

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Bullish case

Now the market is a little bullish one week, and I’m feeling a little bullish as well, so I get the opportunity to buy GFI stock at a premium to what its “fair value” is. The stock market wants to sell GFI stock to me for $110, and being the stock market bull I am, I accept. I have exactly the same dividend stream, but i’ve paid a little more for the stock, so my yield on cost and payback will be different.

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Bearish case

The stock market turns really pessimistic one week and is having a fire sale on GFI. Its pricing GFI stock at $50. I determine that GFI’s prospects are exactly the same and rush in to pick up some of the stock. Again, my dividend stream is exactly the same as above, but my yield on cost and when I recover my investment is different.

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Analysis

So what did we learn from the 3 scenarios above?

• There really isn’t a great deal of difference buying at a slightly above fair value. At the 30 year mark my yield on cost is 43% vs 47.5% where I’ve bought at a slight premium.
• Buying at a slight overvaluation produces a pretty negligible payback impact. I recovered my investment cost back in the 10th year instead of the 11th year.
• Buying at $50 makes a big impact! After 30 years, I’m almost receiving the full price of my investment in my annual dividend alone. I’m nowhere close to this in the other scenarios.
• At $50, my payback happened almost a full 5 years faster than in either of the other scenarios. By Year 30, I have received close to 10 times the value of my original investment!

What are my take aways?

1) Buying quality dividend stocks in any of the scenarios above will provide me with a substantial return on my investment if I’ve invested in a solid company and I have a long enough holding period. Not only am I receiving a sizeable dividend, I’ve been able to fully recoup my investment cost, and then some.

2) Don’t wait for a quality stock to hit rock bottom, it may never get there.  Buying at slight premium to fair value may mean I can tap into a high quality dividend stream and reduce my opportunity cost of not being able to redeploy my capital in an opportunity of similar quality.

3) There’s a lot of value in Buffet’s approach of buying $1 of value for 50c, particularly for a high quality dividend growth stock. Within 30 years, I’m getting almost my full invested capital back in GFI in annual dividends, and I’ve recovered my cost of investment within a little over 10 years. When these opportunities arise, grab them with both hands.

4) Stock market overreactions and corrections can actually change the profile of a low yield, aggressive growth stock into a high yielding aggressive growth stock. This can present a real opportunity to not only collect substantial dividend income upfront, but grow this at a rapid clip.That’s why events like the corrections of 2008 & 2009 are gifts for dividend investors, if you can look past the rubble to pick up these faster growing low yielders.