Dividend investing is a means of building wealth over a long period of time with reduced risk. Many brokers offer fee-free purchases and reinvestments and the ability to reinvest fractional shares. Dividend investing is for the long term buy-and-hold type investor who wants to sleep at night while their investments steadily build.
Articles from The Prudent Investor
The Dividend Discount Model for Dividend Investors – Part 1
by George L Smyth
The Dividend Discount Model is a means of valuing a stock price that is relevant to dividend investors because the theory is based on the sum of all of the stock’s future dividend payments. Part 1 of this article explains the formula and its shortcomings. The second part will speak to fixing those shortcomings and adding a margin of safety.
There are as many ways to evaluate stocks as there are notes on a piano – perhaps more – some better than others, some completely worthless. There is one, however, that is primarily geared toward dividend growth stocks and that is the Dividend Discount Model (DDM).
This theory contends that a dividend stock is worth the discounted value of all dividend payments going into the future. There is a bit more than initially meets the eye in that sentence so I will break it down.
"Life can only be understood backwards—but it must be lived forwards”
I have used this quote from Kierkegaard in the past and will almost certainly use it again because it is relevant to not only investing but also many other things in our life. We can look into the past to build a model explaining events, but going into the future we cannot avoid the requirement of making a list of assumptions.
The DDM is no different. Reasonable assumptions must be made when attempting to divine behavior that may or may not subsequently occur. This involves a degree of risk, which can be mitigated through conservative estimations or augmented by stretching the premises. We all have personal risk levels, so it is important to understand where one's level of comfort lies, and that should be kept in mind when considering this model.
The Dividend Discount Model is a derivation of the Discounted Cash Flow valuation method, which bases enterprise value on future cash flows. The DDM one of the most conservative methods derived from this, and the most straightforward of these methods is called the Gordon Growth Model, which is what we will be examining.
Diving Into the Theory
To begin I will refer to the loaded word used above in the sentence that defines the model, which is "discounted". Understandably, the value of a dividend stock might be worth all future dividends that are received, but the word "discounted" was used, which somewhat changes the picture. The bottom line is that $1 a year from now is worth less than $1 right now. Allow me to explain.
As an example let’s say that a friend asks you to loan them $100, which they will pay back in one year. One year passes and they return the $100, so all is well, except for the fact that you know that you could have placed that $100 in a savings account that offered 5% interest (sure, not possible these days, but let’s make the math easy). Whereas you could have had $105 from that Franklin note you now only have $100, so the $100 a year ago was worth more than it is today.
This is the idea of the term "discounted", the suggestion that future dividends are not worth as much as current dividends, and the further into the future those monies are, the less valuable they are.
If a company offers a $1 dividend per share right now, that $1 might only be worth $0.95 a year from now ($0.95 * 1.05 = $1), and $0.91 two years from now, $0.86 the following year, and so on. Adding all of these discounted values going into the future yields the value of the stock if we are assuming that it is worth the sum of all future discounted dividends.
The below chart extends this example to 50 years.
Adding all future dividends of this example together comes to $19.17, in case anyone is interested. Also, in case there is interest, in this example, year 100 eventually rounds to $0.
This, however, is one of the reasons why dividend growth is so important. If a company raises its dividend by about 5% every year then that would cover the discount in the example above, allowing for a future dollar to be worth a current dollar.
If you wish you may go the route of the scary formula:
Fortunately for us, it can be whittled down to something more manageable:
P = D1 / (r – g)
P is the fair price of the stock
D1 is next year’s expected dividend
r is the discount rate or required rate of return
g is the dividend growth rate.
We can plug some example numbers into the formula to see how this works.
We see that a company is selling at $15 per share and are contemplating a purchase. They currently offer an annual dividend of $0.95 and expect to increase it next year to $1 per share, and that will steadily grow 5% year over year. We have a requirement to make 10% on our money because we know that we can make that elsewhere, so this would be the discount rate. The question is whether or not that other place would offer a better investment than this company’s current valuation.
Entering values into the right side of the formula offers:
D1 = next year’s expected dividend = $1
r = discount rate or required rate of return = 10%
g = dividend growth rate = 5%
$1 / (10% – 5%) = $1 / 0.05 = $20.00
The $20 result is the proper value of the stock according to the DDM. As it is higher than the current $15 value of the stock this indicates that the stock is underpriced by $5 and would offer a better value to the investor.
Note that the dividend growth rate is subtracted from the required rate of return. If the former is larger than the latter then mathematically and logically we are done – mathematically in the respect that the result will be negative and a stock cannot have a negative value, and logically in the respect that if the growth rate is more than is required then the investment is proper.
Of course, nothing is this easy – sure the math is easy but as is the case with anything looking into the future, complications exist.
For one, this formula is primarily suited for companies that have long-term stable growth. High-growth stocks can post a problem with this model if the company’s growth rate exceeds the expected rate of return. With this happening then the denominator will result in a negative value, resulting in a negative amount. This is meaningless, as noted above.
Another difficulty concerns the input of the values, or in the common lingo – garbage in, garbage out. We are assuming a constant dividend growth rate and companies do not do this. I grabbed a copy of the Dividend Champions spreadsheet and looking through over 800 companies saw none that had the same 3, 5, and 10-year growth rates. There will always be some variation in this number.
The 800+ companies in this list are the best case examples, as they have a history of dividend growth. Those without at least a handful of years of consistent dividend growth will offer extreme difficulty in determining realistic numbers that can be placed into this formula.
An additional issue comes with the discount rate. If you know what percentage increase you require then this is not a problem at all. Perhaps you have an opportunity to safely invest somewhere that offers a fixed return and you are trying to decide between placing your money there or with a particular stock. In that case, you know the discount rate.
However, if you are just guessing what the discount rate should be then you may as well not bother in the first place. After all, if you select a discount rate that is too low then everything will look good and if you select one that is too high then nothing will qualify.
This is where the Capital Asset Pricing Model (CAPM) gains importance and it, along with margin of safety, will be the subjects of the conclusion of this article.
Other Articles of Interest
Future Dividend Champions - First of Long Island Corporation
by George L Smyth
With 24 consecutive years of dividend increases, First of Long Island Corporation is nearing the point where they will become a Dividend Champion. It is time to examine it to see if it might be a good fit for your portfolio.
When I think of companies, my mind generally tends toward the large ones. I have filled my portfolio with behemoths like MMM, Aflac, and Johnson & Johnson, market capitalizations respectively of $93, $27, and $390 billion. They are so large that attempting to grasp numbers of that size leads to absurdity. For instance, if one were to stack MMM's market cap in dollar bills, the pile would be over 6,000 miles high. You literally could not live long enough to spend all that money at the rate of $20 per second in a lifetime.
I make this point because a small-cap stock can still have a capitalization of up to $2 billion (a stack of dollar bills about 135 miles high, but spendable in a little over three years), which is still a difficult number to fathom. First of Long Island Corporation sports a market capitalization of "only" $390 million (a stack of dollar bills only 27 miles high, and spendable in just five and a half hours), which makes it one of the smallest of the small companies not in the pink sheets.
First of Long Island Corporation (NASDAQ: FLIC) has been around since 1927, just a couple of years before the start of the great depression. It was 30 years before they opened a second branch, and since 1997 they have raised their annual dividend every year, which includes surviving two recessions. They provide financial services to individual, corporate, and government customers on Long Island, Manhattan, and Queens in New York City.
Above is a five-year chart of FLIC, which shows both opportunity and concern. After rising steeply, it fell in 2018, and then like all other stocks, fell again in March of this year. Understanding these moves will bring insight into the company’s potential benefits and failures.
First of Long Island Corporation primarily relies on its commercial and residential mortgages, so the primary driver is real estate in New York City. In 2018 Manhattan real estate suffered its worst year since 2009, due to an oversupply of high-end apartments, combined with cooling of demand from foreign buyers due to new laws aimed at money laundering.
Chart by Stock Rover
As far as the problem with Covid-19 is concerned, I wanted to see how First of Long Island compared over the past six months with its peers to see if its lack of rebound might be unique. As per the graph above, FLIC is having the same problems that similar companies are seeing during this time.
Of interest to dividend investors are three primary metrics, dividend yield, payout ratio, and dividend growth – what do they have to offer, if they can offer it, and if they offer it willingly. The numbers in this regard are positive for First of Long Island Corporation.
The dividend yield answers the “What do you have to offer?” question with a value of around 4.5%, which is quite attractive. Again referencing the chart above, one can see that the drop in price has doubled the yield since early 2018. But a high dividend yield is not necessarily a good thing if it goes away. The payout ratio offers a clue as to whether or not that is likely to happen.
Payout ratio is the proportion of dividend to earnings, and lets us know if the company is able to sustain its dividend. When it exceeds 100% this means that the company is giving money to investors that it does not have. In the case of First of Long Island Corporation, the payout ratio is around 42%, so there is plenty of room for the dividend. The company has been consistent with this percentage over the years, never getting as high as 45%. The ability to pay is one thing, but the willingness to pay is another, which is why we examine dividend growth.
The fact that FLIC is soon to become a Dividend Champion answers the third part of the equation. Offering not only a dividend but also a dividend increase for 24 years is no easy feat. Even during the housing crash of 2008, when many other banks went belly up, FLIC continued increasing its dividend. According to the Dividend Champions spreadsheet, they have done so not by merely offering a small token increase to maintain the streak, but have been generous to their shareholders.
Dividend growth tells us how important the company feels its dividend is to its shareholders, and the healthy percentages shown in the chart indicate that this is more than a cursory exercise for FLIC. First of Long Island Corporation hits each of the three dividend benchmarks squarely without hesitation.
The final check is that of current valuation. The P/E of 10 is close to what one might expect of a larger bank – small regional banks typically average around 17, so the share price is attractive. Price to Book, which compares the company's market capitalization to its book value, is a more valuable number when examining a bank. Its current value of around 1 places it at neither premium nor discount.
As First of Long Island Corporation is not a growth company, there is no expectation for earnings to shoot up. A general trend upward indicates support to an increasing dividend into the future, and their slow and steady approach brings comfort to the dividend investor. If a company's earnings do not increase it then becomes difficult to allow the dividend to increase.
First of Long Island Corporation appears to be a sound bank with a consistent and attractive dividend that should continue to grow over time. On the other hand, it does not have a diversification of inflows of money, so it is subject to the whims of the New York City real estate market. This issue of diversification could affect share price and be a cause for increased volatility.
In the few days I have looked at FLIC to prepare this article, FLIC has seen quite a bit of that volatility. From August 6-12, 2020, the share price increased by 8% and 20% over the past month. That sounds great, but it is down about a third since the beginning of the year. As I said, this could be a volatile stock, which is commonly not where one who purchases bank stocks wishes to be. I will leave it to the reader to determine how appropriate this small company might be as an addition to their portfolio.