## Using the Dividend Discount Model to Value Stocks

I’ve been devoting my stock research towards dividend stocks recently, or more specifically dividend growth stocks. I am focusing on companies that have a long history of increasing their dividends year after year. Over the long term companies that follow this policy often provide much greater income than other companies that for example may have a high yield currently but never increase their payout.

The vast majority of dividend growth stocks are large cap, well-established companies that are well past their high-growth phase. In fact, this is what allows them to pay dividends and increase them on a regular basis. The management of smaller high-growth companies are often able to achieve better returns by reinvesting earnings in the company, whether it be for plant expansions, new R&D, or marketing. Larger companies are obligated to pay back earnings to their owners (stockholders) in the form of dividends if ROI is too low for any internal investment options.

One of my favorite ways to determine the intrinsic value of a company is through EPS growth capitalization. It’s fast, easy to understand, and it works well under most circumstances. It works best however on companies that are priced for growth – the main inputs into this valuation method are an estimate of future PE and earnings growth. Dividend growth stocks by comparison certainly have earnings growth built into their share price, but more important is the dividend yield and dividend growth. Dividends don’t factor into the EPS growth capitalization method at all (directly), so today I am going to explain the use of another stock valuation method called the Dividend Discount Model (DDM), which is used specifically for dividend growth stocks.

It’s a very simple equation as follows:

IV = D / (r – g)

where:

• IV = Intrinsic Value of the stock
• D = Current annual dividend
• r = Discount rate (%)
• g = Dividend growth rate (%)

The intrinsic value is what we’re trying to determine. Once calculated, we can compare it to the current trading price of the stock and determine whether the company is trading at fair value or whether it is over/underpriced. The current annual dividend is simply found from any stock data website such as Guru Focus. The remaining two parameters in the denominator of the equation require a bit more explanation.

Discount rate: The discount rate is technically the cost of equity for the company, but in simpler terms it can be thought of as the minimum acceptable rate of return (MARR) that we are willing to accept for this investment. Typically this number ranges between 9 – 15%. I use 9% for large, solid “safe” companies, and numbers closer to the 15% range for riskier investments. It should be noted that this number has a huge impact on the results of the evaluation, particularly when it is close to the dividend growth rate.

Dividend growth rate: This is the annual growth rate of the company’s dividend as a percentage. For example, a company that paid a \$1.00 annual dividend last year and increased it to \$1.10 this year would have a 10% dividend growth rate for this year. Rather than simply use last year’s rate though, I prefer to look at how the dividend has increased over time. I look at the 10-yr, 5-yr, 3-yr, and 1-yr compound annual growth rates (CAGR) and either choose the lowest or use an average as my input into the “g” term in the equation. I’ve recently written an article on how to calculate CAGR if you’re unfamiliar with how to do so.

## DDM Example

To make sure this is all perfectly clear, let’s look at an example using an excellent dividend growth stock: Chevron (CVX). This company has a history of increasing its dividend every year for the past 25 years.

• Chevron is currently paying an annual dividend of \$3.60 and is currently trading at around \$118/share for a yield of 3%.
• Chevron is a large, well-established company, but is still growing earnings at 8 – 9% / year. I am going to use a middle of the road discount rate of 12% in this case.
• Dividend CAGRs for the past 5, 3, and 1 years are 9.2%, 9.7%, and 13.6% respectively. To be conservative we will choose the lowest: 9.2%

Feeding these into our equation we determine Chevron’s intrinsic value:

IV = \$3.60 / (0.12 – 0.092) = \$128.57

Today CVX closed at \$117.52, which is about 8.5% lower than the intrinsic value we calculated above. Based on this, it would appear that CVX is slightly undervalued at the moment, however it’s important to use a healthy margin of safety (MOS) to cover any uncertainty in the assumptions made.

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## Dividend Yield vs. Yield on Cost

When approaching retirement, a common strategy is to convert a substantial portion of one’s investment portfolio to income producing securities, whether this be bonds, dividend paying stocks, or even something ultra-conservative such as CDs. If the intention is to live solely off of this income, the most obvious question is: What size must the portfolio be to sustain your desired lifestyle?

The S&P 500 index yields 2.12% at the time of this writing, although individual stocks within the index comprise the full range from those that don’t pay a dividend at all, to those in the double digits. But for argument sake, let’s say that you plan your retirement based on a 2.12% yield. With a \$1 million portfolio, you will have an income of just over \$21,000 per year – before tax! It’s possible to live off this amount (many people do) but it’s possible to do much better, particularly if implementing your investment strategy early.

Specifically I am going to look at how a Dividend Growth Investment strategy can turn that 2% dividend yield into a much more substantial yield on cost. For those new to these terms, dividend growth investing is a method whereby stocks are purchased of companies who have a history of increasing their dividend year after year – essentially the equivalent of an annual raise for those relying on dividends as their primary source of income.

Dividend yields are calculated by simply taking the company’s annual dividend and dividing it into the current share price. For example, if a company is currently trading at \$100 / share and pays a \$5.00 dividend annually, it’s current yield is 5% (\$5 / \$100). Yield on cost however is quite different. YoC is calculated by taking the current annual dividend and dividing into the average cost per share that you paid for the stock. YoC can be much higher than the current dividend yield if the company raises it’s dividend on a frequent basis.

Let’s look at an example using actual numbers. In 2003, Chevron (CVX) was trading at \$43.50 and paid a \$1.43 annual dividend. This works out to a yield of 3.29%. Let’s say you purchased 100 shares back then for a total investment of \$4,350. CVX has increased it’s dividend every year since 2003 (actually for the past 25 years), and is now paying a \$3.60 / share dividend. Assuming you haven’t bought any additional shares in the past 10 years, your total cost is still the same \$4,350, or \$43.50 / share. Therefore your yield on cost is much higher: \$3.60 / \$43.50 = 8.3%

This is the power of starting investing in dividend growth stocks early, and I don’t often see this point emphasized enough. In addition to the stability that dividend growth stocks provide, the additional income arising from the higher yield on cost can be quite substantial.

Let’s look at one more example, this time assuming that \$5,000 is invested in CVX every year for the past 10 years:

At the end of 10 years, we will have invested a total of \$50,000 and will have purchased 701 shares. Our average cost per share is therefore \$71.36 and based on the 2012 dividend of \$3.51, our yield on cost was 4.92%, a whole 1.67% higher than the stock’s current yield. One or two percent may not sound like that much, but that’s actually over 50% higher than the 3.25% current yield!

I hope this helps to explain the power of one of the misunderstood aspects of dividend growth investing. Be sure to try out my free yield on cost spreadsheet to play around with the numbers yourself!

## Lessons from the Intelligent Investor Part 3: State of the Market in 2013

It’s been a while since I’ve posted another entry in my ongoing series for Benjamin Graham’s excellent book, “The Intelligent Investor”. My previous articles have covered chapters 1 & 2. Today I’ll be covering the topics Graham discusses most prominently in chapter 3 — more specifically, a detailed look at the overall state of the market today in 2013.

There are really two trains of thought in the investing world at the moment, with the market now making all-time highs on a daily basis. One is that the market is being irrational and has become overvalued. Investors who share this view are staying away. There are others however that believe the recent run-up over the past few months is just the beginning of an extended bull market. Let’s use some Graham-style logic to assess the situation for ourselves.

I encourage you to read along as we cover Graham’s book from beginning to end. You can pick up an e-book version from Amazon to jump in right away.

Graham’s focus in this chapter was to evaluate the attractiveness of the market at the time of the book’s writing in 1972. We will use the same thought process in an attempt to evaluate where we’re at currently in early 2013. The first thing Graham noted was the fact that there had been over 19 distinct bear-bull market cycles over the prior 100 years – usually occurring every 3 – 5 years on average. We see this same pattern today with extreme market downturns over the past decade in 2001/2002 and again in 2008/2009. The rates of growth in each of this periods varied wildly however.

Graham’s analysis ended in the early 70’s when the book was last published. Let’s pick up where he left off and look at the period between 1970 and 2013:

There were nine bear-bull market cycles during the last 43 years, or one complete cycle every 4-5 years on average. Secondly, we notice that market advances last longer than downturns — 4 years vs. 1 year on average respectively. Finally, gains during advances outpace declines during bear markets quite handily. The average advance in the table above was about 120% while the average decline was about 33%.

This is all fine and dandy, but what can we infer about the market today? First we should note that it has now been nearly four years since the last major market decline ended in 2009 and we’ve seen gains of nearly 130% over that period. Comparing against the historical data above, on average our bull run should be coming to an end soon. We are pretty much bang on as far as the usual length and size of market advances go. This lends some credibility to the train of though that says we’re in for a downturn soon.

Now let’s ignore market cycles and look at the past four decades individually, as summarized in the following table:

Graham noted that only two decades of the entire century prior to 1972 showed a decline in average earnings and stock prices. We can see from our table that the market is as predictable as it was previously, with none of the last four decades showing a decline in either. In fact, both earnings and price have increased at an accelerated pace over the past 40 years.

Let’s compare two very simple gauges of market valuation to the past: the average PE ratio and average dividend yield. These two are not mutually exclusive as they are both affected by changes in the stock price, but it is interesting nonetheless.

Prior to 1970 the average PE ratio for the entire market typically ranged from a low of 10 to a high of 17. Take a look at the 1990s… an average PE of 20! This would have been a good indication of the crash to come in 2001. It’s interesting to note though that from 2001-2010 the average PE ratio remained at the historically high level of 17.

Average dividend yield was much higher on average in the past as well. Before 1970 dividend yields typically fell in the 4% – 6% range. From 1970 – 1990 dividend yields were at the low end of this range at around 4%. More recently however, yields have averaged under 2% at all time lows. This is due in part to companies not paying as much of their earnings out in the form of dividends, as evidenced by the lower average payout ratio shown in the table. Higher prices are equally to blame however.

At the time of this writing, the S&P 500 index is making all-time highs at a level just below 1,600. Let’s try to determine whether this is overvalued, fairly valued, or undervalued, using the analysis Graham uses in table 3-3 in his book. The following table presents today’s picture, along with representative data every 5 years since 1970:

The S&P 500 is currently trading at 16.4 times earnings over the past twelve months, and about 17.2 times the average earnings over the past 3 years. This is toward the upper end of the spectrum, leaning towards being overvalued. It isn’t a solid indication however. Just look at the PE ratios in the 90s — a high PE didn’t stop the market from engaging in the largest bull market in history. Another way to look at valuation is the inverse of PE, called earnings yield. Earnings are currently yielding about 5.8% against a historical range of 4.3% – 12%.

Dividend yields are below average as well, returning just 2% currently. This is an improvement over the prior decade, but much less than the 3-5% yields that were the norm previously. Again, this is an indication of overvaluation.

Finally, let’s compare stock yields to bonds. High grade bonds (10-yr treasuries used in the table above) are at all time lows, yielding just 1.86% today. The earning’s yield from stocks are over three times bonds and even dividends alone are slightly higher. This is very interesting, because despite stocks appearing to be overvalued at the moment, their potential return compared to bonds is at an all time high as well!

Jason Zweig raises an interesting point in his commentary following chapter 3, paraphrased here:

Stock market performance is really driven by only three factors: i) Real growth in earnings & dividends, ii) Inflation, and iii) Speculation by investors which drives prices higher or lower.

Jason postulates that real EPS growth has historically averaged about 2% per year. Inflation over the past decade has averaged about 2.5%. The S&P 500 is currently offering a dividend yield of 2%. Adding these together, we can therefore expect that on average over the long term, the stock market should increase by about 6.5% per year. Fear and greed obviously cause substantial deviations from that average, and that is our goal as value investors to identify those periods (and which one is which!).

In conclusion, I believe that we are due for a market correction based on valuation and the historical duration and size of market cycles. On the other hand, just because the market is overvalued doesn’t mean it is going to suddenly become rational in the near future – especially considering the relative yields of stocks and bonds at the moment. The question arising from all of this is how to change your investment strategy based on this information. My strategy will be to remain conservative, only choosing stocks that appear to be undervalued, and to also be prepared to liquidate a good portion of my portfolio at the first signs of a major correction. There are plenty of potential catalysts for this correction on the horizon, including a financial crisis in Europe, a war in North Korea, and a major economic slowdown in China.

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## Evaluation of Canadian Banking Stocks

Being a Canadian, I try to allocate at least a portion of my portfolio towards Canadian companies. A very small part of me does this for reasons of patriotism, but more importantly I do it to at least partially avoid currency risk. Canadian investors who were fully invested in the US stock market during the past decade probably regret it being that the Canadian dollar increased in value from a low of \$0.62 to par against the US dollar over that same time period. Specifically today I will be conducting an analysis of the major Canadian banks in an effort to select one as an investment candidate. The Canadian banking system is much more stable than that of the US due to tighter regulation among other things, generally pay healthy dividends, and the entire industry is in a period of growth as the Canadian economy strengthens and continues to recover from the financial crisis in 2009. Bob Johnson, a fellow Seeking Alpha author, offered an excellent summary outlining the strength and soundness of the Canadian banking industry which I encourage you to read.

Canada has six major players in its banking industry as follows:

1. Bank of Montreal (BMO)
2. Scotiabank (BNS)
3. CIBC (CM)
4. National Bank (NA)
5. Royal Bank of Canada (RY)
6. Toronto Dominion (TD)

All of these banks are listed on both the TSX and the NYSE, however all of the analysis that follows will be based on the TSX data/prices in Canadian dollars unless stated otherwise. First, let’s look at a quick snapshot of these companies. The following table highlights some of the fundamentals:

For each of the comparative criteria, green highlighting indicates the best, and yellow the second best. There is a large disparity in size between the largest bank (RBC) and the smallest (National), with market capitalizations of \$86B and \$12B respectively. All six banks pay a healthy dividend currently yielding greater than 4%, however BMO and CIBC are edging closer to 5%. Earnings growth over the past 5 years was dominated by TD at about 10.5% annually. Projected earnings growth over the next five years shows an edge for Scotiabank, however these are based on analyst consensus and all are relatively close together in the 6.5% – 8.5% range. From a valuation perspective, National Bank has both the lowest PE and PEG – significantly lower than the other companies. Finally, from a profitability standpoint, Scotiabank is head and shoulders above the rest from a profit & operating margin standpoint, while National Bank offers the best return on equity.

Looking at the above high level analysis Scotiabank seems to have an overall advantage from a growth and profitability standpoint, however National looks to be the best value while at the same time providing the best ROE.

Next let’s look at past stock performance over the past year:

As one would expect these stocks are highly correlated, however there are some observations that can be made. Notable, National and TD have lagged the other four over the past 12 months. Secondly, all banks are off of their recent highs achieved in late February by a significant margin, including a steep decline over the past week due to disappointing Canadian employment data.

Now let’s look at performance over the past five years:

Over the past five years, National was the clear winner, which could explain it’s lackluster performance recently as it may have been overbought. National is a smaller bank and as such is a bit more volatile. I am always interested in buying good value, so let’s use an additional valuation technique to determine whether any of these banks are over or underpriced at the moment. Specifically I am going to use the EPS growth capitalization method. The results are summarized in the following table:

For the above calculations I assumed a future PE of 12 for all companies and I used a discount rate of 9%. Current price, EPS (ttm), and analyst consensus estimated EPS growth rates from Yahoo Finance were used. It’s clear from the above table that National Bank appears to be quite undervalued at the moment. This is inline with the low PE ratio we noticed above. Scotiabank also looks to be slightly undervalued, while the other intrinsic values calculated are so close to today’s price that for all intensive purposes they can be treated as fairly valued. What’s interesting to note, is that these are the same two companies I identified above as being possible investment candidates.

Based on the above analysis, I will be looking to enter into a position in National Bank at or below current price levels within the next week. I will also be adding Scotiabank to my watch list with a target entry price representing a MOS of 15% below the intrinsic value I calculated above of \$62.91. The represents an entry price of \$47.18, which may be possible over the next few months based on the recent weakness due to unemployment.

Disclosure: I plan to take a long position in NA and BNS in the coming weeks.

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## Is CAT a bargain right now?

I’ve been following Caterpillar (CAT) closely the past few months looking for a good opportunity to initiate a position. I’ve been searching for high quality dividend stocks to add to my portfolio to provide an income stream and reduce volatility. CAT has been beaten down from its recent high just shy of \$100 in February to around \$83 as of this morning’s trading. That’s a 17% drop, and I believe it opens the door to position entry. In fact, I initiated a position this morning at \$83.37 on the dip at the open due to the lackluster US jobs report. Following are my reasons why.

Caterpillar is in the business of heavy mining & construction equipment, engines, and turbines. Visit virtually any industrial site and you’re virtually guaranteed to see some of their equipment in use. CAT is a \$55B worldwide company, headquartered in the US but with a large focus on growth regions such as China more recently. General consensus is that the stock has underperformed as of late due primarily to uncertainties in some of the company’s key markets. With the price of gold plummeting, mining companies are becoming more cautious with their capital investments. Demand in China is showing signs of uncertainty as well. I prefer to look at the long term picture though rather than short term fluctuations. Long term there will be an ongoing demand for heavy machinery, and CAT is well positioned to supply that demand. For that reason I am treating this dip in share price as an opportunity rather than a cause for concern.

CAT is currently trading just North of \$83/share at a PE ratio of just under 10. The company pays an annual dividend of \$2.08 which works out to a yield of around 2.4%. Better yet, CAT has increased dividends every year for the past 19 years and with a payout ratio of just 25%, looks capable of continuing this policy in the future. Stock performance itself has lagged the rest of the market due in part to the reasons I’ve outlined above, with share prices down nearly 20% from a year ago and 5% YTD. CAT has a debt/equity ratio currently of 1.58, and appears capable of meeting it’s near term obligations per it’s current ratio of 1.43.

I have used several valuation techniques in an attempt to ascertain what a reasonable price to pay for Caterpillar stock would be as follows:

• EPS Growth Capitalization: Using a future PE of 13 and a projected EPS growth of 9.4% over the next five years, I arrived at an intrinsic value of \$98.14 which is 17% above today’s trading price using a 12% discount rate.
• Discounted Cash Flow (DCF): Using an initial revenue growth rate of 15%, declining to 3% over the forecast period, a terminal growth rate of 3%, and a 12% discount rate, my discounted cash flow analysis resulted in an intrinsic value of \$105.34 which is 19.5% higher than today’s price.
• Dividend Discount Model: Based on a current dividend of \$2.08/yr, a long term dividend growth rate of 5.2% (3-yr avg.) and a 12% discount rate, fair value for CAT works out to be just \$30.91 using the dividend discount model. Clearly what this is saying is that we must rely on capital appreciation in addition to dividend distributions if we are willing to pay today’s prices for this stock. Also dragging this number down was my choice to use the 3-yr average in an attempt to be conservative. The 1-yr and 5-yr dividend growth rates for example are circa 9% and would result in a fair value of \$66 if used.
• Graham Number: Based on earnings of \$8.49 over the past 12 months, and a current BVPS of \$26.86, the Graham Number equates to \$71.63, or about 18% lower than today’s price.
• Other multiples: Using historical PE analysis, PB analysis, and dividend yield analysis, fair value appears to be \$155.18, \$98.51, or \$83.74 respectively.

Throwing away the two extremes (high and low), the fair value range for CAT looks to be between \$71.63 and \$105.34. The average valuation is \$91.47 and the median is \$89.80. Based on this, it would appear that Caterpillar is trading within it’s fair value range, but erring to the low side approximately 9% below the mean. As stated above, I am taking this opportunity to initiate a position despite the low margin of safety.

Disclosure: I am long CAT.

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## Buying Chevron at current Price Levels

As I mentioned earlier this week, I am in the process of adding some long term dividend stocks to my portfolio in an effort to reduce the volatility arising from the growth stocks I own. After further analysis of the stocks in this list, I have decided to buy Chevron (CVX) despite the fact that it is near all-time highs. This may sound counterintuitive from a value standpoint, but based on my analysis, CVX is still reasonably priced, even at \$118 / share.

Chevron is a multinational energy corporation operating in over 180 countries. The company’s primary focus is in the oil & gas industry (both upstream and downstream), but is also involved in geothermal, chemical manufacturing, and power generation. It is the 2nd largest oil company in the US, and employs over 62,000 people worldwide.

As of today, Chevron is trading at \$118 / share and currently pays \$3.60 in annual dividends which results in a 3.05% yield. The company has a solid history of increasing dividends every year for the past 25 years, and based on a current payout ratio of just 27% it would appear that this policy will continue for the foreseeable future.

Chevron has achieved earnings growth of 8.73% compounded over the past 5 years and revenue growth of 3.58% over the same period. Analysts forecast earnings growth 7.6% (source: Morningstar) over the next five years, which is inline with historical numbers.

CVX carried both short and long-term debt, with a debt/equity ratio of 0.09 as of last quarter. The company is in good shape to handle it’s current obligations as evidenced by a current ratio of 1.63. Chevron is currently involved in some ongoing legal issues in several countries, most notably in Ecuador. Un unfavorable outcome could negatively impact the company significantly in the future.

I believe that the rewards outweigh the risks for CVX and will be initiating a position so long as the price is reasonable. In an attempt to determine a fair price to pay for Chevron I conducted several different valuation techniques as follows:

1. EPS Growth Capitalization: Using a future PE of 9.3 and a projected EPS growth inline with analyst estimates of 7.6% over the next five years, I arrived at an intrinsic value of \$101.38 which is 16% lower that today’s trading price using a 12% discount rate.
2. Discounted Cash Flow (DCF): Using an initial revenue growth rate of 5%, declining to 3% over the forecast period, a terminal growth rate of 3%, and a 12% discount rate, my discounted cash flow analysis resulted in an intrinsic value of \$149.22 which is 21% higher than today’s price.
3. Dividend Discount Model: Based on a current dividend of \$3.60/yr, a long term dividend growth rate of 9.2% (5-yr avg.) and a 12% discount rate, fair value for CVX works out to be \$128.57 using the dividend discount model — about 8.7% higher than today’s price.
4. Graham Number: Based on earnings of \$13.32 over the past 12 months, and a current BVPS of \$70.01, the Graham Number equates to \$144.85, or a 19% premium to today’s price.
5. Other multiples: Using historical PE analysis, PB analysis, and dividend yield analysis, fair value appears to be \$123.69, \$100.06, or \$108.75 respectively.

In all, seven different valuation techniques were used, admittedly some more complex than others. Fair value for CVX appears to be in the range of \$100.06 to \$149.22. The average valuation is \$122.36, and median is \$123.69. Based on today’s trading price of \$118, it would appear that CVX for all intensive purposes is within the fair value range, perhaps leaning towards being slightly undervalued.

Disclosure: I am long CVX.

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## What are Bitcoins?

You’ve probably heard mention of the term Bitcoins in the media lately, most likely with little to no explanation as to what they are or why you would want to own them. I fell into this same boat so decided to investigate for myself. Bitcoins it turns out, are a digital currency (i.e. electronic only – no paper or physical coins) that are completely independent of any government and untied to any physical commodity. These coins can be used for online purchases with those (very few at the moment) vendors who accept them, and they can also be sent to any other individual who has a Bitcoin wallet. Bitcoin is the currency of the future, it can be used to pay for many services, like elo boosting services from www.elitist-gaming.com.

At first this sounded dangerous to me – a currency that exists only online, with no regulation whatsoever?? It seemed to me that this would attract nothing but hackers and other individuals who would make the entire system unusable… much like most other unregulated peer to peer systems on the internet. The first question that entered my mind would be how to prevent someone from gaming the system and creating millions of virtual coins for themselves. It turns out the answer to this question is the heart of the system itself:

New coins are generated by Bitcoin users who setup their computers as Bitcoin miners. These computers solve a very computationally intensive mathematical problem in an attempt to generate a solution. Each time a solution is found, it is broadcast to all other computers on the Bitcoin network and the miner receives a reward of 50 Bitcoins for finding the solution. The rate of coin generation is automatically adjusted by the network by changing the difficulty in solving the mathematics by setting a more difficult target (hence requiring more computational time to solve). The goal of this system is to allow for the solution of a new block every 10 minutes on average. Each new block generated must contain the signature (or hash) of the previous block in its solution – and this is the key to preventing tampering with the system. In order for someone to artificially create new blocks, they would need to surpass the computing power of the entire rest of the network combined and not only catch up, but also surpass the rest of the network in new block generation — at least that’s my current understanding of the process.