Investing Articles

This section includes mostly evergreen investing advice.
Here are the top articles to read:
20 Quick Ways to Check a Company
9 Steps to Build and Manage a Portfolio
All About Warren Buffett

Valuation Guide for 2017 + 3 Undervalued Companies

I personally think 2017 will be a good one for the stock market. After going sideways during 2015 and the first couple of month of 2016, the economy has been put back on track with solid numbers and the stock market follows. However, after a strong bullish market since 2009, buying opportunities are getting rare. This is why a strong valuation process is important.

My Favorite Tool for Valuation

There are tons of methods to value companies. Each of them have their pros and their cons. My favorite one is the Dividend Discount Model. It helps me looking at each company as it was a money distributor (I kind of like this idea!). By discounting the value of each dividend payouts, I get an idea of how much I should pay for shares of company XYZ.

The DDM is relatively easy to use, but could sometimes be misleading if our assumptions are to optimistic. By using a low discount rate (meaning you don’t expect much return) or by boosting expected dividend growth rate, you could easily find deals everywhere on the stock market. Therefore I’m offering a small refresh on how I use it.

How to adequately select your discount rate

By definition, the discount rate should correspond to your expected rate of return. If you invest in the stock market, you should expect a minimal return of 7-8%. However, if you use such a low discount rate to make up a value using popular models such as the Discounted Cash Flow analysis or the Dividend Discount Model, you will find that pretty much all dividend growth stocks are trading at a discount. This is not true either.

I try to become more selective in my approach. This is why I use a discount rate between 9% and 12%. When a company is in stellar condition, I will use the 9% discount rate. However, this company must show most of the following criteria:

  • geographically diversified (being a leader in several countries)
  • diversified products (many billion dollar brands)
  • solid balance sheet (low debt and high repayment capacity)
  • unique economic moat (a competitive advantage nearly impossible to replicate)
  • steady and increasing revenue streams

Such companies can be found but they are rare. Most of the time, I find a solid company showing most of those criteria, but there is always something leading me to use a higher discount rate. This is why I pick 10% as a default discount rate. I use 1% less (9%) for exceptional companies and 1% over (11%) for riskier companies. Rarely, but sometimes it happens, I use a 12% discount rate when I think the company has a strong upside potential but also shows some serious issues. I tend to never have more than 10% of my portfolio invested in such companies.

Using a sustainable dividend growth rate

When I see investors using an 8% discount rate, I find it’s not greedy enough. I think they put their investment at risk thinking all their investment will reward them with a 8% return. We all know this is not true and you need stronger picks to compensate. This is why using a 10% discount rate will push many companies aside at the valuation stage.

A similar thinking should be applied toward dividend growth rates. I like using the double stage dividend discount model calculation as I can use 2 different rates. A first one that will be good for the first 10 years and another one that will be used forever after. The first rate could be more generous if it reflects the current situation of a company. When a business is growing in a flourishing economy, we can believe it will become more generous with its shareholders for the time being. After that, it is time to become more reasonable and expect a more conservative rate. The idea is to find the balance between the past 5 years that has simply been amazing and the next 25 years where we can’t really know what will happen.

The Dividend Discount Model – 3 Undervalued Companies

In order to illustrate how I use the double stage dividend discount model (you can check the excel spreadsheet here), I selected 3 companies with undervalued share prices. Those will be a good start for your potential buy list for 2017.

Clorox (CLX) Potential Gain: 43%

The reason an investor would pick CLX to be part of his portfolio is somewhat obvious: it is an ever increasing dividend stock. Clorox is part of the selective group of dividend aristocrats that has increased its dividend for at least 25 years consecutively. In 2016, they have reached their 39th consecutive year with a dividend raise.

The company goals are to support a 3-5% organic sales, improve margins by 25 to 50 bps and to generate free cash flow of 10-12% of sales.

Calculation:

 

Results:

Source: Dividend Toolkit Spreadsheets

Lowe’s (LOW) Potential Gain: +30%

Focus on a recovering U.S. economy and additional growth from acquisitions should continue to push LOW’s stock price higher. Its strong brand and the way it helps its customers to go through bigger projects by offering a “one-stop-shop-&-advice” service will secure LOW’s market share and improve margins over the long haul. Lowe’s has been able to transform a simple home product store into a great service offering for home projects. There is definitely more room for growth in the upcoming years.

Calculation:

Results:

Source: Dividend Toolkit Spreadsheets

Honneywell (HON) Potential Gain +32.5%

Honeywell has made impressive efforts to improve their internal practices over the past 15 years after failing to merge with General Electrics (GE). Those efforts paid well as the company operating margins improved from 7.6% in 2004 to 15.2% in 2014. Those impressive margin increase lead HON EPS to increase by 10% in 2015 as the company is facing a challenging economy. The company was also able to increase its dividend by 10% CAGR over the past 5 years. HON is a leader in the aerospace control and safety systems and should benefit from its leadership position during the commercial aircraft upcycle.

Calculation:

Results:

Source: Dividend Toolkit Spreadsheets

 

Disclaimer: I hold CLX and LOW in my dividendstocksrock portfolios.

My Favorite Tool for Dividend Stock Valuation at 50% Rebate… Until Monday Midnight!

As you know, I’m currently travelling with my family across Central America countries for one year. 100% of my income is coming from my websites. The reason that I’m able to finance my trip through my investing website is that I offer great quality and I’m fully committed to my readers.
Over the past six years, I’ve purchased this blog, built a unique dividend investing platform (DSR) and bought The Dividend Monk. When I bought the Dividend Monk back in March 2015, I did it for a very specific reason; because The Dividend Monk created the most useful tool to determine a dividend stock fair price. The easy-to-use calculation spreadsheet comes with a very detailed eBook explaining how to perform strong and sound stock analysis. This resource is called the Dividend Toolkit.
button

The Dividend Toolkit includes two components:

1) The 200 page PDF Stock Analysis Guide for individual investors, which describes the extremely efficient method to analyze a dividend stock, how to build and manage a dividend portfolio, and what you need to know about MLPs, REITs, and asset allocation. It offers plenty of content, but is divided into modular sections so that it’s easy to read through. The first chunk of the book is introductory content for new investors, and the later part of the book gets into the useful specifics. Even if you rely on newsletters or blogs for your stock ideas, this guide will give you a deeper understanding of your investments and will give you specific tools to check the accuracy of any stock ideas that you’re given.

2) The Valuation Spreadsheet File, which contains a streamlined and easy-to-use tool to instantly calculate the intrinsic value of a stock. Unlike many financial books that give equations without an efficient way to use them, this book comes with the the tool to apply the specific concepts in the book. It has a few different options, including the Dividend Discount Model, so that you can calculate the fair value to pay for any stock.

dgb03

Black Friday 50% Rebate

Since its creation in 2012, The Dividend Toolkit was downloaded several thousand times. The Toolkit usually retails for $19.95 USD but I offer a 50% rebate to bring it down to $9.95 for the package during the Black Friday weekend… this ends Monday at midnight!
button

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.