Value Investing

Introduction

I use an investing strategy called Dividend Growth Investing. In actuality, DGI is a set of strategies that all center on investing in portfolio of companies to produce a growing stream of payments. The ultimate goal is that at some point the dividends will provide an income whose purchasing power is not diminished by inflation. I am currently at a stage in my investing activities where I do not need any of the income my portfolio produces, so I reinvest all the dividends to add more dividend paying shares.

In order to meet my goals, I need to purchase dividend paying stocks at a good price. There are many ways of determining what a good price is, but the one that best suits my goals is one called the Dividend Discount Model.  It is based on the idea a stock is worth all the discounted dividends that it will pay over time. As you can see, a method that values a stock on how much it will pay out in dividends is a good match for my goal of having a steady and increasing stream of dividends.

One common task that an investor performs regularly is deciding which one of two company stock to buy. One of the many factors that go into making that decision is the valuation of the stock. The stock with the better valuation should get some level of preference, and be the one purchased if all else is equal.

As an example, suppose you were deciding on buying either Visa (V) or MasterCard (MA). The main product of each is nearly indistinguishable from the other. In fact, without pulling it out of my wallet I couldn’t tell you whether the card I use most often is from V or MA. Given that I think these two companies make an excellent example of two companies that are the same example for the value offered by their dividend streams.

One resource that I use, and that is invaluable to a dividend growth investor, is a spreadsheet complied by David Fish.  It contains a list of all the companies that are traded on a US exchange and have raised their dividends for 5 or more years. It has a vast amount of financial information about each of these companies related to dividends and earnings.  The latest copy, David updates it each month, is located here.

So what is the value of Visa’s dividend stream?

Above is a screen shot of my DDM calculator.  It is written in Excel, but is based on a calculator I found on the web here. The first input it takes is the dividend that will be paid over the next year based on the latest reported dividend, which for V is $0.66. The next input is the rate at which the dividend is projected to grow for the next 5 years. I used the value from David Fish’s CCC list labeled 5 year DGR.  This is the compound annual growth rate of the dividend over the past 5 years. The next two inputs are the growth rate for the dividend for the 2nd 5 year period and the terminal rate (what the rate will be for the rest of time).  I usually use the same value for both of those inputs, which in this case is 3%. The next input is the expected rate of return or discount rate (it’s called that because each year the value of the dividend will be decreased or discounted by this percentage). The margin of safety input is used when I want to mitigate some identified risks by setting a lower price target.

One feature of my calculator is that is shows how the each of the first 10 years of dividend payments contributes to the total present value (PV) of the dividend stream. Since the growth rate for the first 5 years is greater than the discount rate, you can see how the value added from the dividend increases.  And since the growth rate during the next 5 years is less than the discount rate, you can see how the value added decreases each year.

The terminal value is the value of all dividends ever to be paid from year 11. In order for this value to be finite, the discounted dividend needs to approach $0.  This will happen provided that the terminal rate is less than the discount rate.

So for Visa, we find that the present value of all dividends it will pay out from now is $62.30. The closing price of V on Friday December 9th was $79.14. So dividing the value of the dividends by the price of the stock, I get 0.7872 as the valuation ratio.

And what is the value of MasterCard’s dividend stream?

I use MA’s current dividend of $0.76 and its 5 year DGR value, with all other numbers the same, to calculate the present value of MasterCard’s dividend stream. The increased growth rate makes a big difference in valuation as can be seen in the table of dividend payments.  MA ends up with the PV of its dividend steam being valued at $195.18. The closing price of MA on Friday December 9th was $104.41. The valuation for MA works out to be 1.8694.

So now I have a bunch of numbers, what do they mean?

The task I set myself was to determine based on future dividend payments, which stock was the better value, MA or V. For MA I got a PV value of the dividends of $195.18 which was quite a bit above the latest market price of $104.41. For V even though the yield was actually higher, I got a PV value of the dividends of $62.30.  And the latest market price for V as $79.14.

What these numbers mean is that for every dollar an investor spends buying Visa, they will receive approximately $0.79 in dividends eventually.  However if they put that same dollar into shares of MA, they will get approximately $1.87 in dividend payments. On that basis it seems clear that MA is the better value.

This whole analysis is based on the companies being otherwise equal and being able to grow the dividends at these rates. Given that MA’s payout ratio (the ratio of dividend payments to earnings) is a third lower than V’s, and both are quite low, I think they will be able to maintain robust growth in dividend payments and that MA will be able to keep its dividends growing faster over the next 5 years.

Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended. The price I call fair valued is not a prediction of future price but only the price at which I consider the stock to be of value for its dividends. I hold no position in any of the securities mention and do not intend to establish one in the next week.

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