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The Impact of 1%

In my latest article, I reviewed the methodology used for the dividend discount model. As I concluded, any valuation methods require a lot more than simple calculations in a spreadsheet. In order to find the intrinsic value of a share, it is important to pursue a complete analysis of the whole company. The usage of tools such as a spreadsheet could save you lots of time, but could also result in a catastrophe in your buying process if you don’t pay attention. The smallest variation of any metric could have you pass on a marvelous company or make you buy an overvalued stock at a very bad time. I will show you how a variation of 1% could completely alter the perception you have of the value of a company’s share.

In order to do so, we will start with the previous article’s assumptions for McCormick (MKC):

variation 1

Dividend Growth Rate 1-10 year – Variation of 1%

Fortunately, the first metric to determine is the easiest one and the one that has the least impact on your valuation. If we expect the dividend growth rate for the year 1 to 10 to be 7.50%, MKC intrinsic value is $96.06. However, if we are more pessimistic and determine that the growth rate should be 6.50%, the intrinsic value drops only by $7.92 to 88.14. The impact of 1% less has an impact of 8.24% on the stock price. If you are optimistic, the value climbs by $8.60 to $104.66. Then, the variation of 1% more has an impact of 8.95% on the stock price.

When I determine the value of a company share, I always keep in mind that the first 10 years’ dividend growth rate could affect the intrinsic value by roughly 10% (up or down). Since we already know that the dividend discount model is not perfect, this is a small variation compared to the power of the two last metrics.

Terminal Dividend Growth Rate – Variation of 1%

Intuitively, the terminal growth rate will have a bigger impact in my calculation. This is because we use this growth rate at perpetuity, forever. This is also the reason why I use a smaller number than the short term growth rate. I want to make sure that my calculations are as conservative as possible. With MKC, using a smaller growth rate of 6% instead of 7% brings back the intrinsic value to $68.86. This is a $27.20-dollar difference or 28.32% of the previous intrinsic value. As you can see, this makes a whole difference in the appreciation of a stock. Then again, if we boost the dividend growth rate at 8%, we have an intrinsic value of $177.67. This is an enormous difference of $81.61 more or 84.96% more than the previous intrinsic value. The simple variation of 1% up or down in the dividend growth rate could give you a value anywhere between $68.86 and $177.67. This shows you how fragile the result of your calculation is. Therefore, when you think you have found “THE VALUE” of a company, remind yourself of this example.

Discount Rate

The Dividend Toolkit Calculation Spreadsheet already includes a 1% variation of the discount rate:

variation 2

You can see that the discount rate variation is the most important metric. It amplifies all the other inputs. Then again, if you are getting too complacent and use a low discount rate, you will find the that whole market is cheap. On the other hand, if you request a 10-11% discount rate in all your analysis, you will probably not buy anything for years.

It’s a Combination of Numbers

The other thing that is very important to keep in mind is all these metrics are interrelated. Therefore, you can be very generous on the dividend growth rate and require a higher discount rate and it will almost come down to the same thing. For example, if you use a dividend growth rate of 8.50% for the first 10 years and keep it at 8% for the terminal rate but use a discount rate of 10% instead of 9%, you get a value of $96.63. It is interesting how +1% everywhere brings you back to virtually the same value, isn’t?

variation 3

variation 4

How can you make the right assumptions?

It’s impossible to remain 100% certain that you have the right assumptions. In fact, even if you are a math wiz, you can’t predict the future. Therefore, even if your assumptions are “right”, they could be hit by any storm 5 years from now. How can you make any sense from your calculations then? This is an interesting question.

I’ve solved this question by using a complete analysis process based on 7 dividend investing principles. The valuation is part of 1 principle and I also rely on the 6 others to make sure the companies I select are strong dividend payers. If the company has a strong business model and shows strong metrics, I might end-up buying at a cheap price or an expensive one, but the quality of my portfolio will be improved. To be honest, I don’t really mind about the intrinsic value of a company today, I’m more interested in its valuation 25 years from now.

Dividend Discount Model Calculation Explained

Boosted by a new confidence, the market has hit new record highs lately. Value investors must be grinning at the moment as it was already difficult to find undervalued companies at the moment, a new boost in the stock market is nothing to help. Assessing the right value of a company is quite a challenge by itself, it’s even harder when you have several years of bullish markets to improve any metrics you look at. This is why I decided to revisit the methodology used in my dividend discount model calculations.

The basics of the dividend discount model

The idea behind the dividend discount model (DDM) is fairly simple; this model considers any company as a money making machine (e.g. dividend paying). The purpose of the calculations is to give a value of all future dividend payments that will be made by this company in the future.

This assumes the company will pay & increase dividends forever. This assumption is very important as you have to keep in mind that a very limited number of companies have been successfully increasing their dividend payment for 25 consecutive years. Those companies are called “dividend aristocrats”. There are 50 of them. A more elite group of companies exists where we consider only companies showing 50 consecutive years with a dividend increase. This small group of 18 companies are called the “dividend kings”. You can then imagine how you must remain cautious when you use a dividend growth rate as only 50 companies out of the S&P 500 had successfully increased their payouts long enough to be considered “an eternity of dividend payments”.

The tool I use to run my calculations is called the Dividend Toolkit. The toolkit comes with a 200 page book explaining how to find and assess strong dividend growth payers. This also comes with an excel spreadsheet doing all the hard work for you in order for you to avoid any miscalculation. The spreadsheet allows you to simply key-in the important numbers and it will run the dividend discount model for you without further error. There are two different dividend discount model spreadsheets. My favorite one is the double stage DDM. In this article, I will walk you through step-by-step in order to have the most precise valuation possible. There are four components in this spreadsheet:

Recent Annual Dividend Payment

Expected Dividend Growth Rate Years 1-10

Expected Terminal Dividend Growth Rate

Discount Rate

They are displayed as follows:

DDM explained 1

For the purpose of this example, we will take McCormick (MKC) figures as at July 2016. The idea is not to make MKC stock analysis but rather to take real numbers to show you how they work out in the dividend discount model. As the recent annual dividend payment is quite easy to find. MKC recently increased its payout to $0.43/share quarterly. We already have our first data to enter in the matrix:

DDM explained 2

Now, let’s focus on the dividend growth rate…

Dividend Growth Rate Years 1-10

The first dividend growth rate to enter in the DDM is your assumption of what is going to happen over the next 10 years. This number can be more optimistic as it will only affect a period of time for the calculation. Plus, it has a better chance to reflect the near future of a company. There are many ways you can determine this number. You can use the past 10 years dividend growth history, the past 5 years, 3 years or the most recent year. You can also use other metrics to enhance your analysis.

For example, MKC past 5 years dividend growth rate is at 9%. However, their most recent dividend increase was only of 7.5%. At the same time, the 5 years revenue growth was 5.18% and the 5 year EPS growth was 2.02%. Both recent revenue and EPS growth shows a 9% annual increase is unsustainable. Management seems to go towards the same assumptions as they raised their dividend by 7.5% in 2016. However, I can presume a sustainable dividend increase by looking at the payout (48.91%) and the cash payout (44.39%) ratios. Finally, MKC is spending 50% of its cash flow on business growth (introduction of new products, acquisitions and marketing). This means to me that MKC focuses on generating more revenues and eventually more cash flow for its shareholders. For this reason, I’ve selected a 7.50% dividend growth rate for the upcoming 10 years.

Here’s our second data to enter in our spreadsheet:

DDM explained 3

The terminal dividend growth rate is a little bit tricky though…

Terminal Dividend Growth Rate

The terminal rate is the one to be used “forever”. Already, the word “forever” is big enough, we now have to quantify it. A mistake in your assumption at this stage will render your calculations bogus. In this situation, it is important to give more thought about the company business model, its past history of dividend payments along with what is coming in the future. In other words, you can’t determine a stock valuation without doing its detailed analysis first. In order to save you some time, I’ve already done the McCormick stock analysis on Seeking Alpha. In the light of my analysis, I’ve determined that a 7% dividend growth rate was possible. I always tend to diminish the terminal dividend growth rate vs its first 10 years in order to be more conservative. Here’s what we have so far in our spreadsheet:

DDM explained 4

We are almost done (already!?!) before we get our valuation! All we need now is a discount rate.

Discount Rate

The discount rate reflects the risk vs return you expect from your investment. For example, if we had done the same analysis with treasury bills, the discount rate will have to be very small as it is a “risk free” return. When it comes down to investing in stocks, I use 4 differents discount rate.

9%: for companies with strong economic moat and stellar dividend growth history

10%: for companies with an economic advantage and a strong dividend growth history

11%: for companies showing additional risks (a weakness in their business model)

12%: for long shots

I don’t bother going too high or too low with the choice of my discount rate as it would not serve me well in the valuation process. For MKC, I will use a 9% discount rate based on the fact that MKC is a leader in its market, protects its model by investing massively in marketing and R&D and shows an impressive dividend payment record. In other words, this company shows less risks than Chevron (CVX) for example. We have then completed our spreadsheet:

DDM explained 5

Now… let’s see how much MKC worth if it was purely a dividend paying machine. But first, we must introduce one last concept. The margin of safety.

The Margin of Safety

As you probably realized by now, making these assumptions puts you right between science and magic when it comes down to determining the future of a company. As a small difference in your calculation would lead to completely different valuation, it is important to have a margin of safety. This margin is the room for error in your calculations. The Dividend Toolkit will not only give you the intrinsic value of the company you analyze based on your numbers, but it will also calculate various scenarios where the margin of safety goes from a 20% discount to a 20% premium. Here’s a complete example to show you how it works.

15 Possible Values with the Dividend Discount Model

We are now at the final stage of our calculations. Once you finish your input, you automatically see the result on the right side of the spreadsheet:

DDM explained 6

As you can see, the intrinsic value of MKC is $96.06. However, the Dividend Toolkit Spreadsheet also gives you the value if you had chose an 8% or a 10% discount rate. You also have various scenarios for its margin of safety. For example, if the stock would trade at $75 this morning and you have an intrinsic value of $96, you have a 20% discount value or 20% margin of safety. This means that you can buy the stock at $75 and even if you are wrong in your calculations, you still have 20% on the stock price as a margin of error. On the other hand, if the stock currently trades at $115, you know you are already paying an important premium. In other words, you have no room for error at this point.

As you can see, assigning a dollar value to a company is not that easy. You can get the Dividend Toolkit to help you in your investing process. Using this tool will enhance your investment process and give you a better indication as to when to buy the companies on your watch list and when to wait for a market correction.

The Market is High, is it Time to Invest More?

time

photo credit: If time doesn’t exist, then you’ve never been late in your life. Think about that. lassedesignen/Shutterstock

Do you time your investments ?

 

After such an important rally on the stock market, we have come to the point of asking ourselves as an investor if the party is about the end. We read more and more articles about the next bubble to burst in front of us. The FED has printed too much money, the Chinese market is headed directly into a wall and the European Central Bank has started to mimic the FED and found their own money printer.

Has the stock rally been created from artificially low interest rates and easy access to money or is there a real economy churning behind all this?

Is the stock market is about to collapse?

Or are we going to go through an unprecedented bull market?

 

There is no need to answer all these questions

There is definitely an answer to all these questions and more. In fact, you definitely have your own opinion as I have mine. However, we will only be able to test our answers in a few years when we look back at the charts and say “see! I told ya! It was obvious!”. But trying to time the market and being right about everything that is going to happen in the next 6 months, next year, 6 years is like playing with magic; it happens in the movies but doesn’t quite do well in reality. However, there is something that is a lot more easier to predict and that will keep you happy at night: dividend payments.

 

Dividend Growth Investing prevents you from timing the market

The idea of investing in dividend growth paying companies is the point of buying and holding for a very long period of time, shares of a group of companies that will reward you with quarterly payments no matter what is the weather outside. In general, long term dividend growth companies are less affected by market crashes than the overall market. For example, I’ve pulled out 6 companies that I hold and that meet my 7 investing principles and compared them to the S&P 500 from August 1st 2008 till 5 years later (August 1st 2013):

DM1

Source: Ycharts

 

As you can see, beside Lockheed Martin (LMT), all companies performed better than the S&P 500 5 years after the crash. Also, only one company, Union Pacific (UNP), did worst than the S&P 500 during this period. I could have cherry picked all dividend growth stocks that performed better, but I wanted to pick among my own dividend portfolio (I didn’t hold all these back in 2008, but they are all part of my portfolio now).

I can hear you saying already: “what’s the matter? DivMonk wants to prove us that he can cherry pick stocks that did better during a market crash? Anybody can do this”. You are right to think that. But that’s not what I want to show you. The important graph is the following one:

DM2

Source: Ycharts

The point is that during the market crisis, these companies didn’t only keep distributing their dividend payments, they increased them year after year. This means that while your portfolio recovered from the crisis somewhere between 2012 and 2013, you kept earning your quarterly payments. By the time your portfolio healed fully, your dividend growth portfolio is likely paying 1.5 times the dividend than it used to 5 years ago. You have here a great example of how the power of compounding income can help you weather any market crisis without affecting your investment goals.

Now, imagine if you select strong dividend growth companies and wait 15, 20, 25 years. Your portfolio will go through several storms but you will always earn more money year after year thanks to the ever increasing dividend payments.

 

If you invest by following a simple but effective set of dividend growth rules, you will successfully meet your investing goals.

 

Disclaimer: I’m long JNJ, MMM, KO, LMT, UNP