This article is the seventh in an introductory series on value investing that was first published in 2006 and went on to become the core of our book Value: The Intelligent Investor's Guide to finding hidden gems on the sharemarket.
See also: 1. The essence of value investing; 2. What price a margin of safety?; 3. How to value stocks; 4. Value investing, via Don Bradman. 5. The beauty of book value. 6. Putting a price to earnings.
In the sixth instalment of this value investing series, we saw how the earnings of a company could be split into two elements: one that appears in the form of cash, which can be used to pay a dividend to shareholders or to reduce a company’s indebtedness, and one that appears in the form of other assets, as investment for the future.
Combining these two elements, we saw that the price-to-earnings ratio, or PER, provides a useful short-cut for valuing companies, but that it has its limitations and needs to be cross-checked against other valuation measures.
One cross-check is the price-to-book ratio and another is the dividend yield. You get this, nice and simply, by taking the annual dividends from a company and dividing by its share price. The idea is that this provides you with a smoothed figure for the cash element of the earnings figure. After all, a company can’t go on decreasing or increasing its net debt indefinitely – in the first case shareholders will eventually insist on having their money back and, in the second, the banks will.
The dividend yield has some major advantages: it’s very simple and it takes us right back to our fundamental definition of value, which is the present value of cash that we, the investors, can expect to receive. Unlike earnings, dividends are actual cash flows into our very own bank accounts, and bless them for that.
There are, of course, some shortcomings though, and the first of these is that – unlike the PER – the dividend yield doesn’t factor anything in for growth, so we have to do that ourselves. The simplest way is to assume that a stock’s dividend yield remains at its current level (on the basis that if investors are prepared to settle for a particular yield from a stock’s dividend stream growing at a set rate per year now, then they’ll settle for the same yield sometime in the future). To keep the dividend yield at the same level, the stock price must grow at the same rate as the dividend. Our total return will therefore equal the dividend yield plus the rate of dividend growth.
So if a share has a dividend yield of 4 per cent now, and we expect the dividend to grow at 4 per cent a year, then we’d expect to make a return of 8 per cent a year, and if we edged up our expectations for dividend growth to 6 per cent a year, then we’d expect a return of 10 per cent a year. Turning this around, if a share provided a dividend this year of $1 and we expected this to grow at 4 per cent a year, then if we wanted a return of 8 per cent a year, we’d need a dividend yield of 4 per cent – giving us a value for the share of $25. And if we were aiming for a return of 12 per cent, then we’d need the same share to provide a dividend yield of 8 per cent, thereby halving our value to $12.50.
There are a few other things to look out for with dividends. First of all, you’re only really looking for a company’s ‘ordinary’ dividends, rather than any ‘special’ dividends (which tend to be one-off in nature). Secondly, and perhaps most importantly, it’s important to bear in mind that dividends are just numbers chosen by the directors. In some cases, an overoptimistic assessment of the future will lead to them being set at too high a level and they’ll actually need to be reduced. If you think that’s the case, then you’ll need to make your own adjustment downwards to a level you think is sustainable (and indeed might allow for a little growth).
The big warning sign for a precarious dividend is rising debt. Take the case of Incitec Pivot for example. It has seen its net debt double to $2.2bn over the past five years, while its earnings have fallen. Unless Incitec’s directors discover the secrets of alchemy, we think it’s likely that its dividend will need to be reduced in future.
One way to bypass the directors’ decision on dividends is to look directly at a company’s cash flow, and divide that by the company’s market value to provide a ‘cash flow yield’. The starting point is the ‘net cash flow from operating activities’ (or somesuch), which should be found near the top of a company’s cash flow statement. From this figure you can deduct the ‘net cash used in investing activities’, to leave you with a figure that represents the cash flow that’s available to be paid out as a dividend or to reduce a company’s debt levels.
If you look at Incitec’s cash flow statements, for example, you’ll see that it has managed to generate cash from operating activities of $3.2bn over the past five years, but it’s spent $2.8bn on "investing activities", leaving $0.4bn to play with. Yet Incitec has paid over $0.7bn in dividends, so it’s no wonder net debt has increased to fund the shortfall.
Over the next few articles we'll run through how to sell stocks, one of the most important yet vexing issues in investing.