Does valuation matter for an income investor?

One of my goals is to live off dividend income, without needing to sell any investments for income. But if I don’t sell any capital, then is Total Return that important? And does valuation matter if I only care about continued income?

Total Return

Before answering that question, that’s look at what Total Return is. This simply means the total amount of money earned from the investment, and it consists of two separate parts:

Total Value = Income Paid + Capital Gains

What this says is that for any given investment, the total return is equal to the dividends paid out plus the change in price of the investment. This is then expressed as a percentage of the initial investment. So if you’d bought $1,000 of a stock that paid $30 in dividends and a year later the market value of the investment was $1,070, then the Total Return was 10% ($1,100); $30 from the dividends (3%) and $70 from the price increase (7%).

Total Return when calculated over a number of years is also represented as the annual growth. So a Total Return of 9.27% over a 3 year period is equal to a 3% annual growth over that time.

From an income point of view, I can happily claim that Income is more important to me than Capital Gains. Because I don’t plan to sell any investments then I’ll never need to convert Capital Gains into actual money. So as long as the investments continue to pay Income, then the total portfolio value can take a loss. This isn’t entirely rational on my part since, if I don’t need the income during the accumulation phase and if my investments have a lower total return than the market over the long-term, then I’m throwing money away. And I’m throwing away even more money after adjusting for income taxes. I mention this as being irrational because I’ve not found any evidence that higher dividend yields lead to higher total return. But I personally prefer the convenience of dividend payments.

Rewriting the formula

Now, you may have come across the total return formula written as Compound Annual Growth Rate (CAGR):

CAGR (%) = Dividend Yield (%) + Dividend Growth (%)

When I first saw this formula, it looked strange since Dividend Growth and Yield are two different types of percentages. One is a base percentage, the other a rate of change of a percentage. It’s like adding average vehicle speed to maximum vehicle acceleration which is meaningless. But, the formula is correct although written a little badly IMHO.

I hate the discounted cash flow math which proves the formula, so I made the calculator below to prove it. But although it’s a simple formula it makes certain assumptions that need to be considered. I’ll get to those shortly. But first let’s play with the shiny new calculator.

To use the calculator you enter a Dividend Yield and a Dividend Growth Rate and the number of years. It’ll then calculate the Compound Annual Growth Rate (CAGR) and the total market value of an initial $1,000 investment at the end of that period. (You may need to re-enter the yield or growth numbers after changing the number of years for the graphs to update).

If you have trouble seeing the calculator below, you can download the original Excel file.

With the default values of 3% dividends, at 5% growth over 30 years, the initial $1,000 investment paid out a total of $1,993 in dividends. If those dividends had been re-invested, the total investments would be worth $10,090 for a CAGR of 8.01% as predicted by the 3% + 5% = 8% CAGR.

You can validate the result by using the formula for compound interest e.g.

Total Value = $1,000 * 1.0801 ^ 30 = $1,090.65

Initial observations

You’ll notice that the CAGR rate trends towards the predicted result over time. Entering a short time period won’t get you the expected CAGR rate. The discounted cash flow equations are based on an infinite time span; the number gets progressively closer to the predicted amount as the time duration increases.

You’ll also notice that the CAGR exceeds the predicted result; that’s because of re-invested dividends which increases the total returns. The formula by itself doesn’t consider the additional dividend income and growth from re-investing dividends.

But how does this all relate to Valuation?

Why the formula works

Dividends are paid from Earnings and so an increase in Dividends implies an increase in Earnings. And an increase in Earnings implies a higher share Price since the company is more valuable. Hence dividend growth implies Capital Gains.

I think it’s better to write Earnings Growth than Dividend Growth, but it’s the same amount either way. To obtain a 3% dividend increase with this formula, a company needs 3% more earnings. Stating the equation in terms of Earnings Growth means it can then apply to companies that don’t pay dividends. All (good) companies have Earnings after all.

Anyway, the formula works because both the Payout Ratio (Dividends as a percentage of Earnings) and the Price to Earnings multiple are essentially fixed for the duration of the time period. Which isn’t true in the real world.

Valuation is of course, related to Price and so this means that Valuation matters to Total Return since it affects the amount of Income. The growth portion of the CAGR formula can be estimated based on company fundamentals without any relation to the current price of the stock. The Price really only affects the Dividend Yield portion of the formula. A fast growing company that is projected to grow at 8% should do that regardless if the stock price drops 10% on a given day. And a 10% drop in price will improve the yield and so result in a higher CAGR. Unless of course the reason for the 10% drop is because of lower expected earnings in which case the 8% growth no longer applies.

Choices

So if the stock is over-valued and its share Price is a higher multiple of its Earnings, then the Dividend Yield of the stock will be lower. Since CAGR = Dividend Yield + Dividend Growth, this implies that CAGR would be lower given a higher P/E because the yield is lower, assuming the dividend growth is the same.

Clearly if a stock is priced at $100, then it’s better to buy it at $90 (assuming it’s a fundamentally sound business for the long-term). But the market has decided the current price of the stock and it may take days, months or even years before it returns to the price that you think it should be.

If you’re about to buy a stock but you believe it’s over-valued, then you can either

  1. Do nothing and keep the cash
  2. Buy the stock anyway
  3. Buy another stock that’s better value.

Do nothing and keep the cash

In holding cash, you have opportunity risk which is that you’re losing out to dividend income and potentially higher returns had you bought the stock compared to keeping the cash in a money market or savings account. The long-term returns of cash are lower than the long-term returns of the market, so it requires you to be right about the future market behavior to be a good choice. And cash is probably a worse investment than even an over-priced stock over the long-term. I’m not good at predicting future prices so this isn’t an option I would choose.

Buy the stock anyway

Is it worth just buying the stock anyway and losing out on some income / total return because of a lower dividend yield? Personally, I’d still seriously consider this option if the dividend yield of the stock is within my target limits. If you don’t agree with this option, then you also don’t agree with DRIP investing since DRIP purchases also include their fair-share of over-priced stock purchases due to their automatic nature.

Buy another stock

This is the most interesting option since you can express your inner Warren Buffet and research cheaper stocks. But a cheaper company is also a different company with a different expected Total Return and with its own Dividend (Earnings) Growth. In making a comparison to a different company, more than just Valuation needs to be considered.

This brings up the other variable I briefly mentioned earlier which is important and varies between companies, and that’s Payout Ratio.

Yield in terms of Payout Ratio

Creating the CAGR calculator above, made me realize the interaction between Payout Ratio and Yield and P/E. Let’s start with a simple definition of P/E ratio.

1. P/E Ratio (PE) = Price / Earnings per Share (E)

This can be re-written as

2. Price = PE * E

But we also know

3. Dividend Yield = Dividend per Share (D) / Price

And so putting the Price equation 2. into the Yield equation 3. we get

4. Dividend Yield = D / (PE * E)

Now the Dividend per share (D) is also defined based on a given Payout Ratio:

5. Payout Ratio = Dividends per share (D) / Earnings per share (E)

which we can re-write as

6. E = D / Payout Ratio

We now have a different definition of E which we can put back into equation 4 and get

7. Dividend Yield = D / (PE * D / Payout Ratio)

and this can be simplified to

8. Dividend Yield = Payout Ratio / PE

Using JNJ’s trailing twelve month data as of 11/23 from Morningstar confirms this:

EPS = 5.7
DPS = 3.1
P/O = 0.54386
Price = $112.74
PE = 19.77895
Yield = 0.54386 / 19.77895 = 2.75% = 3.1 / 112.74

Putting it all together

Even in a company’s earnings decrease or remain the same, a company can increase dividends per share by increasing its Payout Ratio. The CAGR formula doesn’t take this into account, and it’s something to consider when comparing two different companies with different growth projections.

A company with a higher P/E requires a higher payout ratio to obtain a given dividend Yield than a company with a lower P/E. This is shown in the chart below.

For example, a company with a 2% yield and payout of 25% has a PE of about 12. A company with a payout of 40% would need a P/E of around 20 in order to pay a 2% yield.

Summary

The trailing twelve month figures for Earnings and Payout Ratio don’t change very often because they are backward looking. The P/E will constantly change however since it’s calculated using the daily price. The daily price is influenced by future earnings and growth projections.

Future earnings growth projections can be compared between two companies to predict Capital Gains returns without needing to consider the current price of the stock. The comparisons on the income side will take valuation into account as it’s reflected in the P/E and yield levels. Companies with a lower P/O ratio have much better potential for dividend increases since they can adjust the ratio in addition to any increases from earnings growth. Companies with high ratios are much more restricted and can rely only upon earnings growth.

Taking both sets of values together and comparing Total Return can help determine if it’s better to take a lower yield from one company or to go with another company instead. Valuation, in terms of the price you pay for a dollar of Earnings matters of course, but growth prospects matter too.

Does valuation matter for an income investor?

Well for me, if given a choice between two stocks paying 3% yield then the one with the lower Payout Ratio is likely the better one. This is also the company that has the lower P/E so it costs less per dollar of earnings. But valuation isn’t my most important consideration and I don’t wait for stocks to reach a certain price level.

I lean more towards the Income side of the CAGR equation than the Growth side since it’s quite difficult to predict the expected dividend growth of a company over the next 30 years or so. I make a decision when I have funds to buy and Valuation is usually represented sufficiently via Dividend Yield.


Quote of the Day

We find comfort among those who agree with us – growth among those who don’t.

2 thoughts on “Does valuation matter for an income investor?”

  1. This is a really great breakdown of dividend paying stocks. Honestly in the past I would pick great companies and then turn on the DRIP and forget about. Looking back I’m not so sure that was smart but I didn’t have a ton of time to devote towards researching other stocks. Normally it takes me about a year to research a stock before I feel comfortable pulling the trigger. This has led to some great picks for me and one or two not so good picks. But overall it’s worked out well but I should probably investigate further. Thanks for the awesome article!!!

    1. Hi MSM,

      Dividend reinvesting is perfectly fine; you’re getting the full total return of the company you own – as long as there are no significant commission fees. It can even be cheaper than regular stock purchases too e.g. my brokerage has a commission free DRIP for stocks, ETFs and mutual funds. The only reason not to DRIP is either to avoid tax Wash Sale issues, to spend the dividend or because you think you might get a better ROI by adding the dividend towards the purchase of another stock.

      Glad you found the article interesting. Valuation isn’t a prime concern of mine when picking stocks – there are other factors to consider e.g. management, competition/moat etc. But I lean towards higher yields which tend to be more value stocks.

      Best wishes,
      -DL

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