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!

 

Packaging Corp of America rising ever higher, is it still the time to buy some?

Summary:

#1 PKG stock price has surged in 2017 compared to its competitors

#2 After 6 consecutive years with a dividend increase, PKG can be considered a dividend growth holding

#3 As the corrugated product industry is declining, we can wonder how PKG will find growth in the future

What Makes Packaging Corp of America (PKG) a Good Business?

Packaging Corp of America is a producer of container board and corrugated products in the US. Further, it also produces multi-color boxes and displays, as well as meat boxes and wax-coated boxes for the agricultural industry. The company is present across the U.S., thanks to the acquisition of Boise Inc in 2013:

Source: PKG investors presentation

PKG shows 85% of business in corrugated containers and 15% in white paper. Its main competitors are International Paper (IP) and Westrock (WRK). Both competitors show larger market cap (22.82B and 14.46B respectively).

Revenue

Revenue Graph from Ycharts

The important revenue jump that happened between 2014 and 2015 is due to the acquisition of Boise inc for $1.995 Billion during the last quarter of 2013. This acquisition opened the territory of Pacific Northwest to PKG and boosted their container board capacity by 42% and their corrugated product volume by 30%.

While we may think the industry of corrugated boxes may be one of the biggest winner of the “Amazon era” where everything is shipped using these kinds of products, the global industry is actually declining:

Source: PKG investors presentation

While PKG specializes in corrugated products and has gained serious market shares (roughly 10% of the market today), the company still evolve in a difficult environment.

How PKG 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%.  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 come with dividend growth and this is what I am seeking most.

Source: data from Ycharts.

PKG dividend yield has been going between 2% and 3.5% for most of the past decade (besides 2 stock price dip in 2009 and 2016). At the current yield of 2.27%, nothing indicates the company is showing any problems.

PKG 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

Packaging Corp of America  made a surprising decision of cutting their dividend in 2009. At this time, the economy was in a deep recession and unemployment rate kept hiking higher each quarter. Management made a courageous decision to cut their dividend upon darker economic outlook for the future. Since then, the company has compensated shareholders with 6 consecutive years with a dividend raise.  A further analysis of the company payout ratios will tell us if history will repeat itself or if this was just a smart move considering the previous headwinds’ management was facing.

PKG 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.

We can now understand how they company cut their dividend as the cash payout ratio rose over 200% the following year. This means the company was burning significant cash and hasn’t enough to pay their shareholders. However, the situation has greatly improved since then.

With low payout ratio and already 6 consecutive years with a dividend increase, PKG is well on its way to become a Dividend Achiever in a few years. 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.

PKG meets my 3rd investing principle.

Principle #4: The Business Model Ensure Future Growth

 

I’ve given some thoughts about PKG business model and I’m not sure where the company advantages will ensure growth in the future. Let’s put it this way: a card box is a card box. The world may need them, but they don’t need PKG’ specific card boxes…

The company has been able to ensure growth through acquisitions over the past decade and enjoyed relatively high margins as the industry is controlled by a handful of players. However, I doubt PKG can find “bargains” to acquire in this industry in the upcoming years.

PKG doesn’t meet 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 a valuation work to be done. 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.

Wow…. Looking at PKG PE ratio is like looking at a roller coaster. Is this company should trade an 8 PE or 28? There is one thing this graph is telling us: the recent stock surge is 100% links to Mr. Market thinking PKG is a great company. Earnings didn’t support such rise.

Digging deeper into this stock valuation, I will 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.

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $2.52
Enter Expected Dividend Growth Rate Years 1-10: 8.00%
Enter Expected Terminal Dividend Growth Rate: 5.00%
Enter Discount Rate: 10.00%

Here are the details of my calculations:

Calculated Intrinsic Value OUTPUT 15-Cell Matrix
Discount Rate (Horizontal)
Margin of Safety 9.00% 10.00% 11.00%
20% Premium $101.15 $80.23 $66.33
10% Premium $92.72 $73.55 $60.80
Intrinsic Value $84.29 $66.86 $55.27
10% Discount $75.86 $60.17 $49.75
20% Discount $67.43 $53.49 $44.22

 

Source: how to use the Dividend Discount Model

While the company raised their dividend 14.5% in 2016, I don’t think this type of dividend growth is sustainable over the long haul. For this reason, I’ve taken an 8% dividend growth rate for the first 10 years and then reduced it to 5% as I don’t see how the business of packaging could possibly surge in the future. PKG seems highly overvalued.

PKG doesn’t meet my 5th investing principle

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 that the company confirms or not my investment thesis. Once the reasons (my investment thesis) why I purchase shares of a company  are not valid anymore, I sell and never look back.

Investment thesis

You can expect I’m not too keen on formulating an investment thesis on PKG. I don’t see any competitive advantage that can’t be replicated by its larger competitors. The company evolves in a slowing down industry where we use less paper and where even the Amazon era can’t boost the usage of corrugated products enough to cope for other segment decline.

 

Potential Risks

After a decade of consolidation in this industry, I don’t see how PKG could possibly purchase cheap competitors. In fact, pressure could come from WRK and IP in a potential price war leading to smaller margins for everybody.

Also, I think it’s important to remember what happened last time the economy entered in a recession: PKG slashed its dividend. While I think it was the right decision at that time for the company, this is definitely not something I want to see as a shareholder. The last dividend cut teaches us two things: #1 management is cautious and responsible (which is a good thing), #2 PKG evolves in a fragile industry where economy cycles have a big impact on their results (bad thing).

PKG doesn’t show a solid investment thesis and doesn’t 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).

 

Unfortunately, while there was an interesting opportunity to buy PKG during the dip in 2016, I don’t see where this company would fit in my holding. Their industry is slowing down and there isn’t much growth potential elsewhere.

Final Thoughts on PKG – Buy, Hold or Sell?

In short: PKG is a sell. If you were lucky enough to buy it in 2016, cash your profit and find a better holding that will pay you growing dividend for several years to come.

Disclaimer: I do not hold PKG 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.

Title: Altria Can be Saved by Its Sister

Summary:

#1 Altria is stuck with a highly profitable product with less and less consumers to buy it.

#2 Management is making serious effort in diversification.

#3 Philip Morris innovative heated tobacco products may become a serious growth vector.

9 years ago, Altria (MO) has made the decision of “unlocking” value for shareholders and spun-off its international division into Philip Morris International (PM). While the number of cigarette smokers is growing throughout most emerging markets, it’s the opposite situation happening in the U.S. where MO is active. While the company is making serious money, where could it go in ten years from now if its clients are disappearing one after the other? Its sister company may have found the solution. Let’s dig into Altria to discover if its worthy of your portfolio.

What Makes Altria (MO) a Good Business?

Altria is one of the largest producer and distributor of tobacco products. These products are highly profitable and lead to repetitive sales. Over the years, regulations around marketing and branding of tobacco products have somewhat protected MO major brands from erosion. Since then, MO benefits from a competitive advantage as its brand is very strong and no marketing can hit it.

However, since the number of American cigarette consumers is decreasing, MO has been working on diversification. Their efforts resume into acquiring 10% of BUD, creating e-vapor brands and operating Ste. Michelle Wine Estates, their smallest but also fastest growing business segment.

Source: 2016 MO investors highlights

However, these efforts haven’t changed MO business model that much:

Author’s table, 2016 annual report numbers

Revenue

Revenue Graph from Ycharts

Since the spin-off, Altria is showing consistent growing revenues. The company benefits from strong pricing power to support this growth. Unfortunately, the reality will hit Altria sooner or later:

Source: Centers of Disease Control and Prevention (CDC)

The number of smokers is clearly decreasing in the U.S. Altria is well aware of this situation and this is why management is looking for diversification. A new hope has risen since PM has developed a new kind of product called IQOS system.

Instead of burning the tobacco, this innovative version of the e-cigarette is heating it. The product is currently being under FDA review to determine which kind of product regulations and taxes will apply to it. MO has the exclusive right on this technology in the U.S.

How MO 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 come with dividend growth and this is what I am seeking most.

Source: data from Ycharts.

MO has always been generous with its shareholders. You can see that as the dividend grew over the past 5 years, MO yield tend to go down. This is because the stock surged by 105.78% over the past 5 years (as at July 19th 2017). At over 3%, MO remains a very interesting stock.

MO 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

Altria has increased its dividend 50 times in the past 48 years. This make the company part of the dividend achievers lists. The Dividend Achievers Index refers to all public companies that have successfully increase 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.

MO 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.

Please note the reason the payout ratio goes went down dramatically is because of the gain realised on AB InBev/SABMiller business combination. In other words, this is a one-time adjustment that should not be considered.

Therefore, the “real” payout ratio is more about 80%. While I’m satisfied with a 80% payout ratio, I will pay a close attention to it in the future.

MO meets my 3rd investing principle.

Principle #4: The Business Model Ensure Future Growth

The core business of MO has been and will remain tobacco products. While Altria benefits from a strong branding and the pricing power that comes with it, its number of clients is decreasing year after year. Additional growth vectors must be added to the equation before it’s too late. The 10% participation in ABInBev, the increasing wine segment and the potential of heated tobacco are enough factors for me to consider Altria a growing company for now.

MO 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 a 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.

If you ignore the recent PE drop due to special item in their most recent quarter, MO is being traded at an ever increasing PE ratio. While I understand the attractive perspective of MO cash flow generation abilities, I start to think it is overpriced.

Digging deeper into this stock valuation, I will 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 MO is able to maintain a 8% dividend growth rate for the first 10 years as MO is generating lots of cash flow and has the possibility to market IQOS (pending FDA approval). However, I reduced the terminal rate to 5% as I don’t think revenue growth will be that strong in the future. Since MO revolves in a very stable and mature market and future cash flow are relatively predictable, I used a discount rate of 9%.

Here are the details of my calculations:

Source: how to use the Dividend Discount Model

MO is showing a 10% upside potential at the moment. However, this is assuming a FDA approval for the IQOS system.

MO meets my 5th investing principle with a 10% 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 that the company confirms or not my investment thesis. Once the reasons (my investment thesis) why I purchase shares of a company  are not valid anymore, I sell and never look back.

Investment thesis

A leading company in a well-protected market is always a good source of cash flow. Altria can continue generating cash for shareholders for several years to come. While growth factors are interesting but not incredible, the outcome of the IQOS system on the market will be crucial. However, regardless of this option, MO is still a solid dividend payer that will continue increasing its payout for the next decade.

MO shows a solid investment thesis and meets 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).

Altria evolves in a mature market with highly predictable outcome. Considering its strong dividend payout history, MO could be part of a core holding for income seeking investors.

MO is a core holding.

Final Thoughts on MO – Buy, Hold or Sell?

While Altria meets my 7 dividend growth investing principles, I’ve decided not to pull the trigger on this one. I’m not too keen about the tobacco industry and sales could erode faster if the company doesn’t come with new products in the next decade. I respect its dividend growth potential, but I will leave MO to other investors.

Disclaimer: I do not hold MO 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.