By: Dividend Sensei
In my last article I explained why valuation is the single most important factor in long-term investing success. Quality, long-term time horizons, both are important, but if you grossly overpay for a company than your returns will fall flat. But how exactly do you determine the fair value of a company? As I explained in part 2 of this series, the essence of a company’s value is the discounted future cash flows. This means that one popular approach is something called a discounted future cash flow model.
This basically calculated all the expected future cash flow, (or earnings), of a company and then calculating how much they are worth today. The same technique can be used for dividends. For example let’s use Dominion Energy, one of my favorite fast growing regulated utilities. It’s highly stable business model, (company has been doing the same thing for about 100 years), which makes it an ideal candidate for a discounted dividend model.
Today Dominion is paying $3.34 per share annually in dividends. Management plans to grow that 10% in 2019 and 2020, and then claims it can achieve “at least 5%” long-term EPS growth after that. If you assume the dividend grows at the same pace as earnings, then you would use a 10% 2 year growth rate, and a terminal rate of 5%. For a discount rate I personally use 9.1%. That’s because since 1871 that’s what a low cost S&P 500 ETF would have generated, net of expenses. Since a low cost S&P 500 ETF is the best default option for most investors, (and what many people benchmark their results against), I consider this the opportunity cost of money. Or to put another way this approach will tell you how much you can pay for Dominion so that its future dividends alone will earn you at least the market’s historical total return.
The answer, per the above assumptions, is $91.76 per share. Dominion is currently 25% beneath that, indicating that the market is pricing in -5.3% annual dividend growth in perpetuity. Given that Dominion has been raising its dividend for 15 straight years, and has a reasonable plan for strong growth in the future, this is likely an overly pessimistic view. In other words if Dominion is indeed 25% undervalued than you have a large margin of safety for the company to disappoint your expectations and still achieve potentially market beating total returns, from dividends alone.