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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!

 

4 Things You Must Do to Protect Your Portfolio from The Next Crash

Over the past 5 years, the stock market has pretty much never stopped increasing:

Source: Ycharts

Between June 20th 2012 and June 20th 2017, the S&P 500 total return is getting us a very nice round number of 100%. In other words; the stock market doubled in value over the past 5 years. We are talking here about a compounding return rate of almost 15% per year during this period. Unfortunately, while the market doubled, the average P/E ratio keeps going up leading to think there is some bubble growing up:

Source: Factset

In the light of both graph, it seems obvious the market is going all the way up for the wrong reasons. There isn’t enough value being created at the moment to justify such hike in price. Does it mean you should sell your stocks and wait on the sideline? This would probably be the biggest mistake you could make. However, this doesn’t mean you have nothing to do to protect your portfolio from a potential crash. Here’s a list of what I’m doing now on my own portfolios:

#1 Review your asset allocation to spot any discrepancies

This is a common step that is often ignored by DIY investors. Did you know the biggest source of losses in portfolio is related to your asset allocation? Each time I came across an investor who lost lots of money, the common theme was the same: the bulk of their investment was in a single industry. As the stock market rose, some industries did better than others. If you haven’t done much trades in the past year and simply looked at your portfolio growing, chances are you are over weighted in some industries.

Therefore, my first step to review my portfolio is to create a simple Excel pie chart using the company name, sector and current value.  Within a few minutes, my pie chart is ready and I get a clear view of what my portfolio looks like:

Source: DSR portfolios returns

You can then easily determine if your asset allocation makes sense or not and identify over weighted sectors where you will need to make transactions.

#2 Review each holding with your initial investment thesis

To facilitate the selection of companies to trade, I then review each of my holdings and look at my initial thesis. Each selection in my portfolio has been made based on my 7 dividend investing growth principles. This is a set of seven investing rules based on decades of academic studies and my own experience as an investor. Principle 6 focuses on the importance of having a strong investment thesis before making any purchases. Once you have identified the reasons why you think a company should be part of your portfolio, it makes it easy to follow it throughout time. Each year, I review my investment thesis to make it still make sense today. As an example, here’s my investment thesis for Lockheed Martin (LMT):

“One of the reasons why I like LMT so much is that it  evolves in a quasi monopoly. They obviously have lots of competitors, but LMT has become THE defense company the U.S. government goes to when it comes down to jet fighters for example. Lockheed Martin has done what BlackBerry did a few years ago by controlling the market. Fortunately for them, it is a lot harder to copy an F35 than a smartphone!

“LMT clients are closely bonded to them for several reasons. First, the trust between both the client and the company is quite important in this case. We are talking about military defense, you will not change your supplier in a heartbeat! Second, the switching cost for their clients would be incredibly high. Lockheed Martin benefits from several long-term contracts guaranteeing a steady income flow. Those contracts are not easily broken. Plus, LMT owns a unique experience in military defense products and services.

“It seems LMT is surfing through the perfect storm. As conflicts are rising around the globe, the Congress accepted Lockheed Martin to seek out for international opportunities. This means the company could enlarge its international sales by doing business offshore.”

Source: The Dividend Guy Blog

As long as LMT will go along with my thesis, I will hold onto this stock. If the business model changes or the industry is not the same anymore, I will not hesitate to pull the sell trigger.

#3 Use a proper valuation model

My third step is to use a valuation model that will help me making my trading decisions. In my opinion, the investment thesis weights a lot more than any valuation model. The main reason being is any kind of valuation model is as good as your assumptions. Unfortunately, it is very easy to make mistakes.

I use a double stage dividend discount model. As a dividend growth investor, I rather see companies like big money making machine and assess their value as such. I think the company will reduce slowly its dividend growth rate compared to previous years as it is clearly unsustainable. Here’s an example of metrics I used to value 3M Co (MMM) another of my favorite holding.

And the calculation results:

Source: Dividend Monk Toolkit Excel Calculation Spreadsheet

The Dividend Discount Model doesn’t own all the answers, but it is a very powerful tool to asses the value of a stock while it is included in a complete investing process.

#4 Make trades, but don’t panic

I know, the temptation of selling your stocks with profit and waiting on the sidelines for the next market dip is very seductive. However, as we never know how Mr. Market’s mood swings will affect our portfolio (we could definitely see another bull market for the next 3 years), I rather have most of my money well invested and cash dividend payouts every month.

The key is to make light changes, tweaks, to your portfolio to make sure your money is well invested. This is not a time to panic nor selling everything you hold. I personally did one trade so far in my portfolio as one of my holding didn’t meet my investing thesis anymore. I might do another one but that’s about it. It’s never a good move to panic or make massive move with your portfolio.

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Disclaimer: I hold LMT & MMM

How many trades should I make a year?

Is there a specific amount of trades an investor should make each year?

Interesting enough, I’ve been called a “trader” from time to time while I define myself as a dividend growth investor. Which type of investor suits me best? I would definitely vote for dividend growth investor, but I will also admit I trade a lot more than the classic dividend investor.

For many, the number of trades you make in a month or a year often define the type of investor you are. If you trade on a daily basis, you are most probably a penny stock trader or a technical analysis fan. If you trade on a monthly basis, you are an active investor, read trader. If you rarely sell any of your holding throughout years, then you can qualify as a buy & hold investor or a dividend growth investor.

I’m having a hard time with these definitions linked to the number of trades completed. In my opinion, there isn’t a minimum or maximum amount of trades you should complete each year. It all depends on where you are at with your portfolio and your investing strategy.

If you are like me and you have decided to divide your portfolio into two sections (core and growth), you will most likely sell one of your holding every year or two. My “growth portfolio” includes companies that I believe are undervalued for a specific reason. These trades are usually more volatile and include a higher degree of risk. In the past, I bought Seagate Technology (STX) while they were in the middle of a growth crisis doubled with a major flood affecting their production capacity. I also bought Apple (AAPL) before the company split as many experts thought their iPhone was about to die (that was before iPhone5… imagine!). Finally, I bought SNC Lavalin (SNC.TO) as the engineering firm was in the middle of a fraud scandal and was brought to justice by the Canadian Government. These are examples of timely trades where I might now keep these companies forever. My investing horizon for such holdings is 18 to 24 months. This is why I will most likely sell one company in my portfolio each year or two.

On the other hand, the core of my portfolio is built with a long term holding horizon in order to benefit from the full potential of compounding dividend growth. These companies are selected upon the 7 dividend investing principles and will most likely be part of my nest egg forever. However, as I previously mentioned, I still follow each of my holdings closely on a quarterly basis to make sure they all continue to show the following criteria:

  • Dividend payment growing each year
  • Payout ratios under control
  • Company is a leader in its market
  • Revenue and earnings on a growing trend
  • Company showing clear competitive advantages

These are key factors to ensure dividend growth over a long period. If a company ends-up failing to meet these criteria or doesn’t meet my investment thesis fundamentals anymore, I will pull the trigger and sell it. I’m not just content about receiving decent dividend income, I want each company I own to be prosperous and grow in value. As the economic environment changes rapidly, it is very possible that a company shows great characteristics today yet loses steam over the years. Some of them just hit a speedbump and are already working on solutions while others can’t find a way to get back on track.

Don’t become trigger happy, but don’t be too complacent

There is a thin line between becoming trigger happy and selling any company that fails to produce growth every quarterly report and being too lenient with management. As much as I want to make sure that each company I hold generates ever growing profits, I can also understand that the economy goes through cycles and there will be poor quarters in any type of industry. The idea is to be able to analyze why there are poor results and to look at what management is putting in place to get back on track.

Making too many trades will only increase your trading fees and reduce your dividend growth potential. Not making any trades could lead to you holding bad companies rotting your total return. There is a balance to reach between the two approaches and this is not easy. I guess the solution is not to determine an ideal number of trades to achieve each year. If you must sell 2 of your holdings during a bad year, so be it. Just make sure you don’t do it out of panic or lack of patience. Always review your investment thesis before pulling the trigger. As long as a company meets the reasons why you selected it in the first place, you should not be in a hurry to sell it.