Are Dividend Stocks Overvalued? Four Reasonable Blue-Chips to Consider

An observation from various articles I’ve been seeing in increasing frequency this past year, including on sites such as Morningstar or Seeking Alpha, has been that dividend stocks, in general, may be overvalued. The articles of course have a range of quality, with some of them going so far as to call dividend stocks a bubble, with others using more reserved and nuanced observations.

It’s certainly an observation worth considering. After all, the Shiller P/E of the S&P 500 remains above the historical average, and I wouldn’t call the market in general undervalued by any stretch.

Dividend stocks may be a particular target of capital, as they are often (but not always) defensive, blue-chip investments with reduced volatility. Plus, a key issue is that interest rates have been so low that even stocks with mediocre yields rival bonds in terms of income while simultaneously offering historically superior total returns.

There are a few ways to examine the question of overvalued dividend-payers.

A) How have dividend payers performed relative to the market as a whole?

B) How are dividend payers valued now compared to historically?

C) How are dividend payers valued based on more objective valuation models, such as the Dividend Discount Model?

A) Dividend Stocks vs. the Market

Comparing the Vanguard High Dividend Yield ETF (VYM), the Vanguard Dividend Appreciation ETF (VIG), and the Vanguard Total Stock Market ETF (VTI), shows that over a five year period, VIG mildly outperformed, VTI was in the middle, and VYM underperformed. Over the most recent year, VYM outperformed mildly, VTI was in the middle again, and VIG underperformed.

Over both a one-year and five-year period, the differences were mild. Over the longer scale of five years, companies that focus on dividend growth outpaced high-yielders and the stock market as a whole, whereas over the shorter term of the past year only, the trend reversed itself and high-yielders outperformed the market and the dividend growers.

The comparison doesn’t exactly lend itself to the thesis of dividend stocks being substantially overvalued.

B) Current Valuations vs. Historical Valuations

The second way is to compare several dividend stocks to how they were years ago. One article I read, from Barron’s, literally said dividend stocks were at “nosebleed valuations”. (But then later went on to indirectly define that as “20 to 25% overvalued”, and the article was reasonable). I’ve also seen some articles throw the word “bubble” around.

So where do dividend stocks stand today in terms of valuation?

Johnson and Johnson (JNJ) trades for over 21x earnings, which I think is on the high side, but much of this was due to recent decreases in EPS rather than large stock price expansion. Ten years ago, JNJ was trading at over 25x earnings.

Walmart (WMT) trades for a bit over 15x earnings after a large recent spike in price. Ten years ago, the valuation was approximately double, at around 30x earnings.

Procter and Gamble (PG) trades for over 21x earnings, which again I think is on the pricey side. Ten years ago, the valuation was a bit higher, at over 23x.

Southern Company (SO), listed by the Barron’s article as a poster child for the overvaluation of dividend stocks, is over 18x earnings, and in my recent analysis, I said it was moderately overvalued. Ten years ago, it was over 16x earnings. So it has gone up… a bit.

Coca Cola (KO) is rather expensive as well, at over 20x earnings. Ten years ago, the valuation was double that, at over 40x earnings.

I can only go through a limited number here, although I’ve purposely selected stocks that I’m not exactly buying at current prices. I think we can safely cross words like “bubble” or “nosebleed valuations” off of the list, and stick to the more nuanced questions like, “are dividend stocks moderately overvalued?” and “is the stock market in general a bit expensive at these prices?”

C) Objective Valuation Approaches to Dividend Stocks

My preferred method of stock valuation rests not on relative comparisons, but instead on absolute metrics. Discounted cash flow analysis relies not on any external comparisons, but instead determines the fair price of a stock based on the amount of cash flow it can produce.

The Dividend Discount Model (DDM) uses this method and is tailored specifically for dividend stocks.

Using it, we can find several companies that pay good dividends that are reasonably valued.

McDonald’s (MCD) currently trades for under 17x earnings, and is a robust and defensive name with three and a half decades of consecutive annual dividend increases. Earnings have grown by an average of 16% annually over the past seven years, while the dividend has grown by over 24% annually over the same period, although this must slow down. Based on the DDM, McDonald’s only needs to grow the dividend at 7% per year going forward (or alternatively, 11% per year for 10 years and 5% per year after that) in order to justify the current stock price of around $90/share with an expectation of 10% annual returns.

Aflac (AFL) is potentially a deep value pick at well under 9x earnings, with almost three decades of consecutive annual dividend growth. This insurance company’s core business remains incredibly strong, but they do have 5-6% of their portfolio in risky European debt. Over the past several years, they have realized losses on their balance sheet due to European debt exposure and have worked to contain and eliminate those risks. The dividend has grown by an average of 18% annually over the past seven years, as the payout ratio has increased but remained low. At the current rate of EPS growth, if Aflac grows the dividend by 15% per year over the next ten years, they’ll only have a 50% payout ratio. If after that point, they grow dividends by 6% per year, then the DDM reveals the current price of around $46 to offer potentially 12% long-term returns. There’s certainly risk here, but if you’re looking for stocks on the other end of the valuation spectrum, a quality company like Aflac is one of the better places to start.

Emerson Electric (EMR) sits near the top of the list of consecutive dividend-payers, with comfortably over 50 years of consecutive annual dividend increases. The company is a leading provider of automation, process management, network power (focusing on data centers and telecommunications providers, two areas I’m bullish on), and climate technologies. At under 16x earnings, the stock trades for a reasonable price. The dividend has grown by an average of over 9% over the past seven years, although it was a bit low during the recession. According to the DDM, Emerson only needs to grow the dividend by 7% going forward in order to produce 10% annual returns.

Republic Services (RSG) is the second largest trash collector in the United States. With a decent economic moat from its large ownership of landfills, and annuity-like cash flows, RSG barely has to grow at all in order to provide decent returns through dividends and stock buybacks. The company only has to grow the dividend at 6% or better for the long term to provide 9% long-term returns, based on discounted cash flow analysis via the Dividend Discount Model.

Conclusion

Although I do think the market as a whole is modestly expensive (via the Shiller P/E for an overview as well as inspection of individual securities), dividend stocks in general do not appear to be at dangerous valuations. Some areas do seem to be heated (conservative utilities, certain telecoms, some consumer products companies, in particular), but to balance those out, there are other areas of reasonable valuation (cyclical industrials, insurance, blue-chip tech, and even a few defensive names like McDonald’s).

There are some slightly more advanced tools to work with, such as selling cash-secured put options to get good returns while waiting for better prices, but overall, sticking to sound valuation principles still reveals some reasonable stock choices out there.

Full Disclosure: As of this writing, I am long JNJ, PG, KO, MCD, and EMR.
You can see my portfolio here.

Strategic Dividend Stock Newsletter:
Sign up for the free dividend and income investing newsletter to get market updates, attractively priced stock ideas, resources, investing tips, and exclusive investing strategies:

OVER 7,000 READERS RECEIVE MY DIVIDEND PICKS

Comments

  1. I think a nuanced view is about right. Things are expensive, largely due to yield seeking spillover from bonds. But “bubble” is silly.

    That said, my primary positions right now are long SPY/short dividend stock spreads.
    http://www.offroadfinance.com/2012/08/24/a-speculative-alternative-to-investing-part-6-wrap-up/

    These are not speculative positions, not investments. But they do illustrate that I think certain stocks are a few percent overpriced. These bets have been mildly profitable in the current bull spurt over the last month or so, but they’d likely be much more profitable if we had more turbulence in the S&P.

  2. I appreciate your writing, depth of study and general approach. But I have to say that stating that JNJ isn’t expensive because 10years ago it was 25x is cherry picking. This is the highest ratio since late 2005. I’m long JNJ but it’s just a hold at these prices for me:) Keep up the good work and thanks for sharing.

    • Matt Alden says:

      Thanks for the comment.

      JNJ was described in the article as one of the “stocks that I’m not exactly buying at current prices”, and the 10-year price comparisons were one of three methods to determine valuations.

      Because EPS dropped, they are reasonably expensive. That section of the article was devoted towards talking about the notion that stocks are at nosebleed or bubble valuations. Many blue-chip stocks were more expensive 10 years ago than today in terms of earnings multiple.

      Discounted cash flow is the #1 absolute way to test a stock valuation; the other methods are relative.

  3. Ventureshadow says:

    RSG carries a huge amount of “goodwill” on its balance sheet, comparable to its book value, so it is less attractive. I have nothing against the other stocks mentioned.

  4. Matt,

    Great article and I completely concur with your conclusion that the market is modestly overvalued. Seeing as such, I’ve been a bit pickier on where I want to allocate capital.

    I agree with your picks, specifically MCD and AFL. I think they are both wonderful places to allocate capital for long-term appreciation in today’s market. EMR and RSG are also strong, but EMR does trend below $50 often and that’s the time to buy. I recently bought around $45 and would be more than happy to do so again.

    KMI, GD, INTC are all near the top of my list. LEG to a degree as well. And KO if it trends down to $35.

    I’m hoping for a 5-10% correction in the near term and believe we may get some of that if the Fed meeting is a little less opaque than usual..and especially if they outright denounce further QE.

    Best wishes!

    • Matt Alden says:

      I agree with you about under $50 being the time to buy for EMR.

      Back in late January, I wanted to increase my stake in EMR, but the price was around $50, which I considered reasonable, but without a decent margin of safety.

      So I sold some Jan 2013 puts at $6.70 each at a strike price of $50. So the cost basis for that buy would be $43.30 if the options were exercised, which will generally occur if the price goes under $50 around the time of expiration. But from a value investor perspective, I don’t really care what the stock price does; only what the value is, and I’d prefer to enter when valuations are on the lower side. If the option is exercised, I’ll get the shares. If the option expires without being exercised, I’ll write another option on the stock, and get another premium.

      If this valuation environment continues, and with “fiscal cliffs” and so forth, I’ll be continuing to enter positions via put options if there aren’t decent margins of safety around. A few picks, like MCD, I’d just buy outright, but for others, I’ll use cash-secured puts as a slightly more conservative investment to keep my cost basis lower.

  5. I agree that the market is a little overvalued, due to already having core positions in a number of blue chip dividend paying stocks I can afford to be pickier than most. The best strategy for me to use at this time is to sell puts against these great businesses! Keep up the great work!

  6. The overvaluation comes into play when high dividend yield (4% or more) stocks compete with a weary fixed income market. With interest rates so low ( manipulated by the Fed), the market is forcing valuations higher because these are substitutes for bonds.

    When an investor chooses JNJ because its an adequate substitute for a 10 year treasury, the P/E becomes irrelavant.

    JNJ probably should trade lower at a greater than 4% yield based on its fundamentals.

    What will happen when interest rates go up? We shall see. You need to be careful and buy stocks that are supported by the cashflow.

Trackbacks

  1. […] 9. Are Dividend Stocks Overvalued? Four Reasonable Blue-Chips to Consider @ Dividend Monk. […]

  2. […] -Are Dividend Stocks overvalued? @ DividendMonk […]

  3. […] Are Dividend Stocks Overvalued? Four Reasonable Blue-Chips to Consider by Matt Alden – “Although I do think the market as a whole is modestly expensive (via the Shiller P/E for an overview as well as inspection of individual securities), dividend stocks in general do not appear to be at dangerous valuations.” [Aflac has been on my almost buy list for over a year – John] […]

Speak Your Mind

*