How I Value Dividend Stocks

I'll try to explain my method as clearly as possible since a number of readers have asked me about this.  I'm going to walk you through step by step, with pictures, to show you how I calculate the fair value for an individual dividend stock.  Again the final number will be a fair value, not necessarily a target buy price.

I use the average of four valuation techniques.  Two are forward looking, two are based on historical facts.  I'll run through the calculation with XOM since it was one of my latest purchases.


Dividend Discount Model:
You can use google to learn about the theory if you want, I'm not going to get into that.  However, it will tell me what the expected future dividend payouts are worth in today's dollars.  Quite useful to an income investor such as myself.  This is forward looking.

Current Dividend.  I used yahoo.com

5 Year Dividend Growth.  I used fidelity.com

 

Input the first two values.  I use a 10% discount rate with the exception of utilities and telecoms.  This is a spreadsheet setup by JC at http://www.passive-income-pursuit.com/ 

XOM has a FV of $62.92 based on DDM.  XOM didn't do very good here.  Fortunately I don't use this technique exclusively.


Discounted Cash Flow Model:
This valuation technique is also forward looking and can be used for all types of c-corps, not just dividend stocks.  If a stock has EPS of X that is expected to grow Y% per year, what is it worth in today's dollars?  DCF has an answer to that question.  If you want more information about DCF, please google it.  This post is going to be long enough as it is.

EPS taken from yahoo.com

This number is derived from analysts expectations and taken from fidelity.com

Again I use a 10% discount rate.  I used a free online calculator at the following website: http://moneychimp.com/articles/valuation/dcf.htm

XOM did great with the DCF calculation.  Again this is only one calculation.  Let's not get too excited yet.  $125.33


Average P/E:
Most if not all value investors place at least some faith in the P/E ratio.  It's a quick way to gauge a company's valuation.  That's great and all, but just knowing the P/E ratio won't tell me much.  Is a 15 p/e good for XOM?  What about a 10 p/e?  Well one way of answering that question is to see what the historical p/e for XOM typically is.  If XOM has a historical p/e of 10, I would argue that when the current p/e is 10 it is fairly valued.  Anything less than 10 is attractive, while anything over 10 could be considered be over valued. 

The goal here is figure out an actual dollar amount.  Saying "over valued" or "under valued" isn't good enough.  I want to break it all down into one number.

You can see the 5 year average P/E is 11.4  Since XOM has a current P/E of 9.1, it is obviously under valued according to this technique.  That's not good enough, I need a number.  I'm going to assume 11.4 means fairly valued and extrapolate a price using the current EPS.  Taken from Morningstar.com

XOM has a current EPS of 9.83  Taken from yahoo.com

So if XOM had a P/E of 11.4 (historical average) I would consider it fairly valued.  If it had a 11.4 P/E right now (based on the current EPS) it would be a $112.06 stock.  Indeed XOM does look undervalued here.  Now I have a number!


Average Yield:
This method is very similar to the average p/e.  Dividend stocks are often bought because they provide income!  If the current yield is high, investors will snatch up shares.  If XOM yielded 5% right now, everyone and their brother would be buying as much as they could.  I know I would.  XOM wouldn't stay at a 5% yield for very long.  Think about that.  It's a key driver, along with EPS and dividend growth, of why income stocks tend to appreciate in value over time.  When a stock has a high yield it is worth more to an income investor. 

So how do we know what a decent yield for XOM is?  Average yield.  I consider the average yield to be another indication of fair value, just like average p/e.  If you can get in at the historical yield you are not over paying because XOM is an income instrument.  Now we have to put it into a number.

It is quite obvious that XOM normally offers a lower yield than it does today.  An indication that it is under valued.  This picture was taken from Morningstar.com



Current Dividend.  I used yahoo.com



If XOM yielded 2.3% right now (the historical average or another way of saying fairly valued), the stock price would be $109.56. 


Calculated FV for XOM Stock:
Take the average of the four calculations and you'll get $102.46.  The last time I performed the calculation is was closer to 103.  I bet the low current p/e dragged down the historical average a little, while the high current yield increase the historical yield a tiny bit since the last time I crunched the numbers.  I only do them once per quarter, it is quite tedious.

These are the four methods I find most useful.  The ones that fit my strategy as a hybrid income & value investor.  I don't want to dwell on the past, yet I cannot predict the future.   I find great comfort in the history of fantastic, proven companies.  Can the streak continue?  How accurate are analysts?  I try to take all that into account.

This is not an exact science, and should be considered an estimate!  Be aware that p/e's expand and compress over time.   Be aware that interest rates might affect dividend stocks because they are income instruments.  If I could get a 6-7% yield on bonds backed by the full faith of the US government, I'd have to think long and hard about buying an equity with a 2.8% yield.  At 10%, bonds are a no-brainer.  I like to use a 5 year period because it encompasses the great recession.  Using a 10 year period might be a better historical comparison.  Then again a business can change drastically over 10 years.  There are other useful techniques.  Some people use the graham number.  I don't.  It's up to you!