Too many investors ignore stock valuation when they purchase dividend stocks for income. There’s a tradeoff. They simplify the investing process by averaging into quality businesses but risk having a higher average cost for their dividend investment. Consequently, a higher cost leads to a lower initial dividend yield (and lower subsequent yield on cost when the dividend stocks increase their dividends).
How do you tell a dividend stock’s valuation?
Some investors do not know how to value dividend stocks. Understandably, there isn’t a clear-cut formula to determine if dividend stocks are undervalued, fairly valued, or overvalued. Too many factors come into play, including the stability of the business’s earnings or cash flow, the historical valuation, the growth rate in the future, the safety of the dividend, etc.
If you’re not sure about how to determine if a stock is cheap or not, use the analyst consensus price target as a guide. Although sometimes there are big changes for these price targets after an earnings report, it’s still better than ignoring the valuation factor altogether.
The more stable the business is in question, the less changes there will be for the price target. For example, the snapshot can be found on Yahoo Finance. It shows the current fair value range for Fortis (TSX:FTS)(NYSE:FTS) based on analyst 12-month price targets. The average price target is the one you should compare the current stock price with. It indicates Fortis stock is discounted by 4.5%. So, I would consider Fortis as fairly valued.
There should be little to no surprises for Fortis stock’s fair value quarter to quarter. The regulated utility generates highly stable and predictable returns. Management anticipates a long-term growth rate of 6% from its new $20-billion capital program for 2022-2026. So, in the long run, I expect Fortis’s fair value price target to nudge higher year after year as it executes its low-risk capital plan and increases its dividend by about 6% annually.
When it’s not as straightforward to tell a dividend stock’s valuation…
Cyclical dividend stocks, including industrial and energy stocks, will have a higher probability of experiencing jumps (up or down) in their price targets. The first examples that come to my mind are Magna International (TSX:MG)(NYSE:MGA) and Suncor Energy (TSX:SU)(NYSE:SU).
If you’re interested in investing in these kinds of dividend stocks, to protect your capital, you can simply require a bigger margin of safety before investing in them. It’ll come with experience how big of a margin of safety should you wait for before buying a given dividend stock. Also, you should be aware where they’re in a cycle. You should aim to buy at the trough of the market cycle.
From the fundamental analysis chart below, it would seem we just missed the trough of the cycle for Magna stock. However, if you plan to invest for at least three years, the dividend stock appears to be cheap on a forward basis. Notably, the stock experienced two years of earnings decline before turning around. That’s the kind of cyclicality interested investors must be ready to endure.
Investors got a scare when the then Canadian Dividend Aristocrat, Suncor stock, cut its dividend during the pandemic. Apparently, its dividend wasn’t as well protected as its peer Canadian Natural Resources (TSX:CNQ)(NYSE:CNQ). Suncor just restored its dividend to the 2019 level. And now offers a yield of over 5%. Oil prices have rebounded and pundits believe the WTI price will stay at least in the US$70 per barrel level over the next year. So, that yield appears to be safe for now. Suncor could be an interesting trade at current levels.
The Investor Takeaway
When buying dividend stocks, other than checking for dividend safety (payout ratio, earnings or cash flow stability), also account for the stock’s valuation and the stock’s earnings/cash flow growth expectations over the next few years from a macro level. This way, you have a good chance of increasing your overall dividend yield from the get-go.
If you like what you've just read, consider subscribing via the "Subscribe Here" form at the top right so that you will receive an email notification when I publish a new article.Disclosure: As of writing, we own shares of Fortis.
Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.
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