Apple: A Growth or Dividend Growth Stock?

Summary:

#1 AAPL stock price rose by 65.37% over the past 5 year lagging the S&P 500 by about 9%.

#2 However, the company has also increased its dividend by 65.36% for a 10.58% CAGR.

#3 Combined together, AAPL stock outperformed the market.

When I first purchased shares of Apple (AAPL), it was way after their original stock surge. I added AAPL to my portfolio once they raised their dividend for the first time, right before the stock split. At that time, there were lots of concerns around the company’s ability to “survive” in the smartphone industry and continue to generate growth. After a thorough analysis, I made the bet that AAPL would become another Microsoft (MSFT); a company generating strong cash flow and increasing its dividend generously. Almost 5 years after my first trade, let’s look at Apple and its dividend growth potential.

What Makes Apple a Good Business?

Apple is an icon of the techno which survived the techno bust in 1999. Their products are made with great attention and aim at perfection. While its products are not perfect (yet), it has built a perfect product ecosystem. Your MacBook, iPad, iPhone, and your Apple Watch all blend together. You can share your pictures, favorite songs, and applications with any device. Apple has succeeded to have fans instead of customers.

Revenue

Revenue Graph from Ycharts

The company is still highly dependent of how their iPhones sales are going. For example, during their latest quarter (Q3 2017), the company shows 55% of its sales coming from the iconic smartphone:

Author’s chart, AAPL Q3 2017 numbers

While this seems like a red flag to many investors, I see something else: a year ago, iPhones were 65% of its revenue (source MarketWatch). Considering the iPhone 7 was launched in September 2016 (after the MarketWatch article has been written), we see the company is reaching serious momentum in their Services division. Over the past 12 months, this sector has increased its revenue by 22%.

How AAPL fares vs My 7 Principles of Investing

We all have our methods for analyzing a company. Over the years of trading, I’ve been through several stock research methodologies from various sources. This is how I came up with my 7 investing principles of dividend investing. Let’s take a closer look at them.

Source: Ycharts

Principle #1: High Dividend Yield Doesn’t Equal High Returns

My first investment principle goes against many income-seeking investors’ rule: I try to avoid most companies with a dividend yield over 5%. Very few investments like this will be made in my case (you can read my case against high dividend yield here). The reason is simple: when a company pays a high dividend, it’s because the market thinks it’s a risky investment… or that the company has nothing else but a constant cash flow to offer its investors. However, high yield hardly comes with dividend growth and this is what I am seeking most.

Source: data from Ycharts.

As far as my first principle goes, we can’t tell AAPL has a high dividend yield! This is probably what an income seeking investor will tell you if you asked about their opinion on this stock. Unfortunately, a 1.50%-2% yield doesn’t attract the dividend-growth crowd. After all, don’t forget that MSFT started just like that:

Source: Ycharts.

AAPL meets my 1st investing principles.

Principle#2: Focus on Dividend Growth

Speaking of which, my second investing principle relates to dividend growth as being the most important metric of all. It proves management’s trust in the company’s future and is also a good sign of a sound business model. Over time, a dividend payment cannot be increased if the company is unable to increase its earnings. Steady earnings can’t be derived from anything else but increasing revenue. Who doesn’t want to own a company that shows rising revenues and earnings?

Source: Ycharts

What really matters to me is the dividend growth. While AAPL dividend growth history is relatively new, it shows the kind of trend I’m looking for. With a 10.58% CAGR dividend growth rate over the past 5 years, AAPL is up to a great start to become a Dividend Achiever in no time.

AAPL meets my 2nd investing principle.

Principle #3: Find Sustainable Dividend Growth Stocks

Past dividend growth history is always interesting and tells you a lot about what happened with a company. As investors, we are more concerned about the future than the past. this is why it is important to find companies that will be able to sustain their dividend growth.

Source: data from Ycharts.

While management’s committed to provide shareholders with ever-growing dividends, the company has lots of room to meet its promise. You can expect a double-digit dividend growth for the next decade.

AAPL meets my 3rd investing principle.

Principle #4: The Business Model Ensure Future Growth

I don’t think Apple is a one trick pony at all. It used to rely on its MacBook sales for a while, then it invented the iPod and surfed on this wave for a while. The current “new trick pony” is the iPhone, but Apple is already working on various other products. In the meantime management can enjoy what is the most important thing for any company… cash flow!

Source: Ycharts

Apple is an innovative company that has the resources and the will to continue in this path.

AAPL still shows a strong business model and meets my 4th investing principle.

Principle #5: Buy When You Have Money in Hand – At The Right Valuation

I think the perfect timing to buy stocks is when you have money. Sleeping money is always a bad investment. However, it doesn’t mean that you should buy everything you see because you have some savings aside. There is valuation work to be done. In order to achieve this task, I will start by looking at how the stock market valued the stock over the past 10 years by looking at its PE ratio:

Source: data from Ycharts.

After being given a very low multiple for about 2 years, AAPL seems to be back to its average valuation. Mind you, I think there is still room for a higher multiple considering the current market valuation.

Digging deeper into this stock valuation, I will use a double stage dividend discount model. As a dividend-growth investor, I’d rather see companies like big money-making machines and assess their value as such.

Here are the details of my calculations:

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $2.52
Enter Expected Dividend Growth Rate Years 1-10: 10.00%
Enter Expected Terminal Dividend Growth Rate: 8.00%
Enter Discount Rate: 10.00%
Discount Rate (Horizontal)
Margin of Safety 9.00% 10.00% 11.00%
20% Premium $389.63 $193.54 $128.23
10% Premium $357.16 $177.41 $117.54
Intrinsic Value $324.69 $161.28 $106.86
10% Discount $292.22 $145.15 $96.17
20% Discount $259.75 $129.02 $85.48

Please read the Dividend Discount Model limitations to fully understand my calculations.

According to the DDM, AAPL currently trades at its fair market value. However, if I had to initiate a position in AAPL, I would gladly do it at fair market value. This is the type of company that will show a great combination of dividend growth and capital growth in the future.

AAPL meet my 5th investing principle but with limited upside potential.

Principle #6: The Rationale Used to Buy is Also Used to Sell

I’ve found that one of the biggest investor struggles is to know when to buy and sell his holdings. I use a very simple, but very effective rule to overcome my emotions when it is the time to pull the trigger. My investment decisions are motivated by the fact of whether the company confirms my investment thesis or not. Once the reasons (my investment thesis) of why I purchase shares of a company are not valid anymore, I sell and never look back.

Investment thesis

The company is already evolving to find other sources of revenue to stop being “the iPhone company”. Apple TV, iWatch, Apple Music, and Apple Pay are their most recent innovations. The company continues to offer a great product ecosystem and add more products that can connect to each other. This perfect ecosystem continues to attract more customers away from Androids to connect with Apple products.

Potential Risks

When you look at any “techno stock”, there is always a great risk. What is a premium product (the iPhone) today could become the next joke amongst geeks in the span of 12 months. It happened to BlackBerry (BBRY) and it could happen to Apple at any time.

AAPL shows a solid investment thesis and meet my 6th investing principle.

Principle #7: Think Core, Think Growth

My investing strategy is divided into two segments: the core portfolio built with strong & stable stocks meeting all our requirements. The second part is called the “dividend growth stock addition” where I may ignore one of the metrics mentioned in principles #1 to #5 for a greater upside potential (e.g. riskier pick as well).

As previously mentioned in this analysis, AAPL shows a combination of both capital and dividend appreciation. While we are looking at a very solid company, AAPL still evolves in the technology sector. For this reason, AAPL stock could definitely go up or down rapidly upon shocking news. For this reason, I think AAPL would be a better fit in a growth portfolio than in a core one.

AAPL is a growth holding.

Final Thoughts on AAPL – Buy, Hold or Sell?

I’ve been a happy AAPL shareholder for many years now and I would not hesitate to enter into a new position if I was building another portfolio. AAPL is definitely a buy until it goes to a ridiculous value such as $200…

Disclaimer: I do hold AAPL in my DividendStocksRock portfolios.

The opinions and the strategies of the author are not intended to ever be a recommendation to buy or sell a security. The strategy the author uses has worked for him and it is for you to decide if it could benefit your financial future. Please remember to do your own research and know your risk tolerance.

Where do you find value in this market?

While I’m an eternal optimist, I must admit the current market value is making me a little bit uncomfortable. When you look at the S&P 500 average PE history, we rarely hit above our current PE average. Worst; each time it happened, valuation crashed not too long after.

Data: multpl.com

Should I stop investing? Should I wait? These are questions we all ask ourselves right now. But, in the end, I know something; the market always wins. Betting against the market is a bad idea. Waiting for the market to crash before investing would make me leave a lot of dollars on the table in the meantime (because we don’t know when the market will ever crash!). I have another question for you instead: where do you find value in this market? If you can answer this question, you will not have to worry about investing at an all-time high.

Where to start

Instead of trying to figure out when the market is about to crash, I rather work on finding value. The market is not on sale as it was a few years ago. The easy money is gone but it doesn’t mean you can’t find any interesting companies.

I always start my search with a focus on dividend growing stocks. I’m looking for companies that focus on increasing rewards for investors. Therefore, if I ever run into the bad luck of investing new money right before a market crash, I make sure that I will get well paid to wait until my portfolio recovers. A good start for my research is the dividend achievers list. The Dividend Achievers Index refers to all public companies that have successfully increased their dividend payments for at least ten consecutive years. At the time of writing this article, there were 265 companies that achieved this milestone. You can get the complete list of Dividend Achievers with comprehensive metrics here.

I like the Achievers as they count newer dividend growers in their list. Focusing on the Dividend Kings or the Aristocrats limits investors to “old” dividend growers that might now find many growth vectors within their mature business model.

I also pull out an equity search to find strong growers over the past 5 years. A long dividend growth history is nice, but companies that have been able to raise their distribution recently are better. There are currently great opportunities with younger dividend growers such as Disney (DIS), Apple (AAPL) and Starbucks (SBUX).

Beware of the fundamentals

I like to compare the high of bull market to a big wave. When the wave rises, it brings everything on top. If you are in the ocean, you can’t do anything else but follow this huge power. Fishes, shells and even garbage are taken from the bottom and raised to the top. When the economy is doing well, it often happens that even the worst companies show good numbers.

When we look at macroeconomics data, we see unemployment rate is low, inflation is low, rates are low and consumer confidence is… high! This could become a toxic cocktail as consumers have access to cheap money and they tend to buy more stuff since they have a good job and they are confident in the future.

Therefore, when you pull out 5 year history data for many companies, chances are you will find raising revenues and earnings. Debt payments won’t slow down companies as debts are cheap right now. For this reason, I tend to be more demanding and add stronger criterions. For example, I will not accept payout and cash payout ratio over 100%. Ideally, I will even consider only companies showing ratios under 80%. I want to make sure dividend payouts will continue to raise even if the market crash.

My Favorite places to find value right now

As I mentioned earlier, I found that DIS, AAPL and SBUX are currently trading at an interesting price. I’m also adding Lowe’s (LOW ) to this short list. While they are very different companies and are not in the same sector at all, they all share many similarities:

#1 Their dividend yield is low (under 2%) and ignored by many income seeking investors

DIS is paying 1.45% yield, AAPL 1.61%, SBUX at 1.80% and LOW recently passed the 2% mark at 2.09% since the stock lost 9% of its value over the past 3 months. In a low interest environment, income seeking investors are looking for investments to return low yield bonds. Investing in low yield stocks doesn’t really meet their criterion. This is why I feel these companies are being ignored in this bullish market.

#2 Double-digit dividend growths over the past 5 years

While their dividend yield is not impressive, their growth pace is. DIS shows a 15.77% annualized growth rate, AAPL 10.72%, SBUX at 24.08% and LOW at 26.68%. Besides AAPL, they all doubled their payments within the past 5 years.

#3 Their payout ratio is low (under 45%)

After showing such strong dividend growth, I would expect payout ratio to be relatively high. I was pleased to find out that the highest rate was SBUX at 44.40% followed by LOW at 41.62%, AAPL at 27.14% and finally DIS at 25.79%. No matter what happens in the upcoming years, I know those 4 companies will continue raising their dividend as they have lots of room to do so.

#4 Business model generating strong and increasing cash flow

These four companies don’t only show good earnings, but they also show their ability to grow their cash flow from operation year after year. More cash in the bank account also means more cash to be distributed as dividend payment!

#5 They all show strong growth vectors for the future

Disney has created an important growth vector through their movie division. The acquisitions of Marvel and Lucas Film (Star Wars) have created an unlimited box of blockbuster ideas. Their ability to multiply their revenue coming from those movies is quite impressive too. For each movie, there will be multiple gears, toys and apparel sold.

Apple has created a very sticky product ecosystem making Apple customers more fans than clients. While AAPL relies mostly on their iPhone sales to generate their cash flow, their service business (Apple Pay, Apple music, etc.) is growing rapidly.

Starbucks has lots of room to increase its store numbers. But management doesn’t stop there. Through their membership application, the company is able to know what its clients want and modify their offer accordingly. This is how SBUX has improved its menu, store sizes and business hours.

Finally, Lowe’s completed a major acquisition in Canada with Rona last year. I expect it will learn from this experience, generate synergy and eventually go for more acquisitions in the future. LOW has a solid business model in the U.S. and can export it to other countries.

After going through a deep analysis of each company’s business model, I also used a double-stage dividend discount model to value each stock. The idea is to give a value to the future dividend payments. Therefore, no matter what the market is doing, I keep my focus on increasing dividend payments and their value. Those four companies have proven to be traded at a discount value.

What about you? Have you found any undervalued companies right now?

 

Disclaimer: I own DIS, AAPL, SBUX, LOW in my DividendStocksRock portfolios.

Dividend Discount Model Limitations – And How to Manage Them

For each stock analysis I perform on my blog or for my portfolios, I always include a section about valuation. To be honest, the valuation part of my analysis is not my favorite… and not the most important either in my opinion. I prefer working on my investment thesis and assessing potential risks than shaking my crystal ball and give a dollar value on the shares. Is it because I’m bad at giving valuation? Not really. The problem is that I’m well aware that regardless the method I use, there are severe limitations that could make two investors using the same model, but getting completely different results. Today I will take a look at the dividend discount model (DDM) limitations and how I deal with them.

How the Dividend Discount Model Works

The reason I like using the DDM for my work is because the formula is simple and effective. The purpose of this model is giving a value for future dividend payments. It’s basically giving you the value of your “money making machine” based on how much it should pay you back in the future. The model has been built around the following formula:

P is the price of the stock, D1 is next year expected dividend, R is the rate of return (discount rate) and G is the dividend growth rate. Therefore, in order to complete the formula, you “simply” have to determine the discount rate and future dividend growth rate as the payable dividend is already known.

How can you make mistakes with such as simple formula? Unfortunately, nothing is simple in finance and while the DDM sounds simple, it comes with several shortcomings.

Dividend Discount Model Flaws

Regardless of the method you are using, the first flaw of all calculation models will be the same: the model is as good as its input. You can put any kind of numbers you want and results may vary. This is why it is so important to understand specific flaws for each model you use. Here’s the list for the DDM:

Constant dividend growth rate

Based on the original formula (also called the Gordon Growth Model), calculations are based on a constant dividend growth through time. This assumption is completely wrong and likely never going to happen in real life. For the rest of this article, I will use a well-known Dividend King: 3M Co (MMM). Here’s MMM dividend growth rate for the past 30 years:

Source: data from Ycharts

While MMM has increased its payout for 58 consecutive years, you can see that its dividend growth rate has greatly fluctuated overtime.

The Fix:

By digging into the company’s dividend growth rate history, you can get a better idea of its average. After looking at how management grew its payouts, you can also look at how revenues and earnings are growing recently. To improve your accuracy for the dividend growth rate, you can also use a double-stage DDM. This will allow you to select a first dividend growth rate for a specific period and a terminal growth rate for long term payouts.

Which Dividend Growth Rate?

Then again, we hit another difficult value to determine. Should you use the last year previous growth rate that is very close to the current company’s situation? Or should you give it some thought and consider a larger growth history?

The Fix:

If you use the double stage DDM, the first number should be close to what the company has been going through over the past 5 years and the terminal rate should reflect more the overall history of the company’s growth rate. This is not a simple task, but let’s takes a look at how MMM grew its dividend:

  • 5 years: 14.77% annualized return
  • 10 years: 9.367% annualized return
  • 20 years: 7.73% annualized return
  • 30 years: 8.01% annualized return

If you combine this analysis with the current company’s payout and cash payout ratio, you should have a very good idea if management has enough room to continue their last 5 years growth rate or not. MMM currently shows a payout rate of 50.78% and a cash payout rate of 50.92%. Last year, MMM rose its dividend by 5.85% and the year before, the growth rate was of 8.29%. You can then see that the 5 year dividend growth rate isn’t going to be a good choice for the next 10 years.

A more reasonable growth rate of 8% sounds more appropriate. As a terminal growth rate, I rather go with conservative values. In this case I think it’s fair to assume MMM can keep a 6% growth rate considering its 30 years annualized growth rate being 8%.

Various discount rates applicable

There are various discussions about which discount rate to use.  I mean, what kind of investing return do you want? Or do you expect? This question leads to a very subjective answer. If you are being too generous (e.g. looking for low discount rate), you will find the whole market is on sale all the time. On the other side, if you are being too greedy (e.g. looking for a high discount rate), you will never buy anything… but value trap!

The Fix:

According to financial theory, we should be using the Capital Asset Pricing Model (CAPM). This is another formula used to describe the relationships between the risk of an investment and its expected return:

As you can see, to determine the discount rate, you now have to determine several other variables. The Risk Free return refers to the investment return where there is virtually no risk. It is usually referred to the 3 months T-Bill return. As of August 4th 2017, Ycharts shows the 3 month T-Bill rate at 1.06%.

Going forward, the beta determines how a security fluctuates compared to the overall market. A beta less than 1 means the security fluctuate less than the market and vice versa. You can easily find stock beta on free websites such as Google Finance. For example, MMM beta is set at 1.06 as at August 4th 2017.

Now, the last metric to be used is the expected return of the market. This number could be widely debated. If you look at the S&P 500 total return over the past 5, 10 and 20 and 30 years, you get completely different numbers:

  • 5 years: 14.63% annualized return
  • 10 years: 7.93% annualized return
  • 20 years: 6.89% annualized return
  • 30 years: 9.90% annualized return

I would tend to discard the 5 year and 30 year results. The last 5 years don’t include a full economic cycle while things were a lot different back in 1987 and I don’t think we can expect such growth in the future. I guess the answer lies between the 20 and 10 years. To be fair, let’s use the average of both; 7.41%.

Here what should be the discount rate: 7.79% = 1.06% + 1.06*(7.41%-1.06%)

This is Quite a sensitive model

We are now ready to use our double-stage DDM and see if MMM is trading at an interesting value or not. Using the numbers described in this article, we have the following data:

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $4.70
Enter Expected Dividend Growth Rate Years 1-10: 8.00%
Enter Expected Terminal Dividend Growth Rate: 6.00%
Enter Discount Rate: 7.79%

 

Then, running the calculation will give us a fair value at $331.30…

 

Discount Rate (Horizontal)
Margin of Safety 6.79% 7.79% 8.79%
20% Premium $907.05 $397.56 $253.41
10% Premium $831.46 $364.43 $232.30
Intrinsic Value $755.87 $331.30 $211.18
10% Discount $680.29 $298.17 $190.06
20% Discount $604.70 $265.04 $168.94

 

We will all agree MMM is NOT undervalued by 60% right now. The DDM is giving us a completely ridiculous value with a discount rate of 7.79%. Please note that I’ve selected dividend growth rates that are matching or below MMM 5, 10 , 20 and 30 years history. Therefore, I can’t really cut on those numbers already. However, if you look at the chart, my Excel spreadsheet gives me two more results according to a discount rate of 6.79% (-1%) and 8.79% (+1%). Interesting enough, the intrinsic value of $211.18 seems more appropriate already. But you can see how sensitive the model goes when 1% makes the difference between $755, $331 or $211 for the same stock.

The Fix:

The fix is obviously to put everything into perspective. Should I expect a higher market return and go back to my CAPM calculation? Because if my discount rate is closer to 9%, I get a valuation that is closer to what MMM is trading for. My fix for this problem is not to use the CAPM… huh? Yeah, you read it right, I use a different system based on the rest of my analysis.

Instead of using historical numbers and academic concept, I’ve decided to use 3 different discount rates according to the company’s situation:

9%: The company is well-established, a leader in its industry and shows stable numbers. Example: 3M co

10%: The company is well-established, a leader in its industry but shows an element of risk or fluctuation: Example: Apple (AAPL)

11%: The company shows important flaws or imminent menace to their business model. Example; could be Garmin (GRMN) since their core business (auto GPS) is melting

Then, by using my Excel spreadsheet, I have 3 different discount rate and 10% – 20% margins of safety calculated all at once. It helps giving the proper valuation to the company.

Final Thoughts

As you can see, we could all use the DDM on the same company and get several different answers. In the end, your valuation will be as good as your assumptions. Unfortunately, one point up or down in the calculation matrix and you can go from “BUY” to “SELL” in a heartbeat.

For this reason, it’s important to have a margin of safety and a range of calculation to give you a clear idea of whether you should buy, hold or sell the stock you analyze.  The tool I use to calculate the DDM is found in The Dividend Toolkit. The Toolkit also includes a complete section on how to use the DDM and other valuation methods such as the Discounted Cash Flow model.

Finally, no matter how much time you spend on your valuation method, this will not likely be the reason of your success or failure as an investor. What will really determine if you can manage your own portfolio is your ability to develop a complete investing process and stick to it afterward. You can read about my detailed investing process here. It will give you a good head start!