By: Dividend Sensei
Last week I went through some more advanced techniques for valuing stocks which I myself find useful. However there are two simpler and more direct methods that may be easier for those looking for a quick rule of thumb approach.
The first is based on a simple formula that was pioneered by Myron Gordon, an economist who worked at the University of Toronto. In 1956 Gordon built off earlier work from John William’s 1938 research, (“The Theory of Investment Value”), to create what has proven to be as close to a magic formula for predicting future returns as you’ll likely ever find. It’s called the Gordon Dividend Growth model and it basically says that over the long-term the total returns for a dividend stock will closely approximate yield + dividend growth. This is because yield represents a stock’s valuation when you bought it. Dividend growth is a proxy for earnings and cash flow growth.
Basically what history has shown is that a stock’s valuation, in this case yield, generally will cycle through a relatively tight range, but is mean reverting. Meanwhile over time a company can pay out only so much in dividends, because it needs to keep reinvesting into future growth. The bottom line is that yields don’t tend to fluctuate that much in the long-term, and reasonable dividend payout ratios mean that dividends must track earnings over time.
So for example if a stock currently yields 3% and can be expected to grow its dividends over the next 10 years by 7%, then you can probably expect to get about10% total returns. Another way to think about it is this. At 7% dividend growth over 10 years the dividend will double. If you bought a stock at 3% and the dividend then doubles, (paid for out of earnings and cash flow that also doubled), then the market can be expected to double the share price to bring the yield back down to 3%.
This works best for reasonably stable blue chips, for which predicting dividend growth is realistic. But how exactly can you determine a reasonable dividend growth rate? Well history can be a guide, say by checking the 20 year dividend growth rate. Another way is to use something like Fast Graphs to see what the analyst consensus is for dividend and earnings growth for the next decade. Of course the best source would be long-term management guidance, since the executives running the company have the most insight into what kind of growth they can achieve.