The Great (Valuation) Debate - Part II
Good Morning. With the stock market indices clearly in an uptrend at the present time (although a pullback in the near-term would surprise no one), this appears to be a good time to continue our look at the various valuation metrics. This morning, we will take a look at the Price-to-Dividend Ratio from three different perspectives.
One of the reasons that many analysts prefer to look at P/D ratios over P/E ratios is dividends represent cold, hard cash that companies have decided to return to shareholders. Unlike earnings, that can be distorted or "financially engineered" in any number of ways, the amount of money a company's board of directors decides to part with each year is a pretty darn good proxy for the board's confidence level.
However, before we go on, I should point out that while dividends do indeed represent real cash being paid out to individuals, the payment of dividends has gone out of favor over the last 20 years or so. The problem is two-fold. First, the tax treatment of dividends is not favorable. And second, with Wall Street's focus having increasingly become whether or not a company's earnings "beats" the consensus estimates each quarter, companies have instead decided to buy back shares of stock. You see, buying back shares of stock avoids the "double taxation" that dividends incur and also helps improve the almighty EPS number.
The math here is simple really. In order to calculate earnings per share, the company divides the total earnings by the number of shares outstanding. And if the number of shares outstanding shrinks due to a share buyback program, well, EPS goes up - even if earnings stay the same. Thus, buybacks have become an important part of the financial engineering that takes place at the end of each quarter. But unfortunately, this has occurred at the expense of dividend payouts.
However, the P/D ratio can still provide a pretty good picture of stock market valuation - if you know how to use it correctly. So let's take a look at a few of these P/D ratio indicators and see what we can learn.
Price-to-Dividend Ratio: As you may have surmised already, the plain-vanilla P/D ratio has "issues" these days. The key is that since 1925, there have been four distinct ranges for the P/D ratio. For example, from 1925 through the late-1950's the P/D reading was mostly in a range between 12 and 37 (except for the Great Depression, when it went below 5). Then from 1957 through 1974, the range tightened considerably with the low in the 23 zone and the high around 40. Next, from 1975 through 1992, the range was between 19 and 37. And finally since 1995 the low has been 26 and the high has been close to, wait for it... 90!
Since 1925, the average P/D reading has been 27.6. Thus, this becomes our baseline or "normal" valuation level. Over the past 50 years, the average has been 39.2. And over the past 25 years, the average has soared to 51.8. However, prior to 1995, the P/D had NEVER been above 40. So, while the current reading of 48.29 may sound like it is below average relative to recent readings, it is still off the reservation from a long-term perspective. Furthermore, the range of the P/D since 2000 has been between 25 and 90. Yikes.
So, from where I sit, the straight-up, plain-vanilla P/D is somewhat impossible to parse these days.
Adaptive and Smoothed P/D Ratio: Since the traditional P/D is borderline useless at the present time, we need to attack the problem from a different angle. One way to do so is to first take a four-quarter average of the P/D ratio and then to slap standard deviation bands around a moving average of the P/D. This approach will first smooth out the readings and then will adapt to changing environments over time.
Given the massive range that the P/D has experienced over the past 25 years or so, this approach makes a lot of sense. However, as you might suspect, this is a longer-term indicator. But, the good news is that we can get a reading from the indicator at this time that may be helpful.
Although the range of the smoothed P/D remains large over the past 25 years, the addition of standard deviation bands and a moving average allow us to ascertain where overvalued, undervalued and fair-valued readings exist.
As of June 30, the current reading of this indicator was 40.78. While this is a relatively high reading, the moving average currently stands at 45.2. Thus, we can argue that relative to recent history, the DJIA is modestly undervalued.
Real Dividend Yield: The final method we will explore today is a little off the beaten path. The concept is to plot "real" dividend yields over time. The "real" dividend yield is calculated by taking the dividend yield of the S&P 500 and then subtracting inflation from it - in this case, we will use the year-to-year change of the Consumer Price Index (CPI).
Since 1925, when the real dividend yield has been above 0.3%, the bulls have prevailed. The computers at Ned Davis Research tell us that the S&P 500 has gained ground at an annualized rate of nearly 10% per year when the real dividend yield is over 0.3%. When the real dividend yield is between 0.3 and -2.1, the S&P has gained at a rate of 5.9% per year. And when the real dividend yield is below -2.1, the S&P loses ground at a rate of -5.0% per year. Thus, it is safe to say that these levels represent good indicators for under-, over- and fair-valuations.
As of the end of May, the reading of the real dividend yield was +0.6%. This is above the 0.3% mark and as such should be considered moderately undervalued.
In sum, the valuation business is anything but a perfect science. However, the message we can take from the dividend indicators we've reviewed is that while the readings may be elevated from a long-term perspective, the relative indicators suggest that the bulls should be given the benefit of the doubt here. Or put another way, stocks are not dramatically overvalued at the present time relative to the last 25 years.
Turning to this morning... Although Asia was higher overnight, Europe is trading lower. And with the earnings parade kicking into high gear, traders in the U.S. will have their hands full deciphering the results. Also worth noting this morning is the level of oil futures, which are currently over $107 as well as the drop in interest rates (the yield on the 10-year is at 2.524%). U.S. futures are currently trading mixed and are pointing to a flat open.
Positions in stocks mentioned: none
The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning’s opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program. The opinions and forecasts expressed are those of the editor and may not actually come to pass. The opinions and viewpoints regarding the future of the markets should not be construed as recommendations of any specific security nor specific investment advice. One should always consult an investment professional before making any investment.
Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided.
The analysis provided is based on both technical and fundamental research and is provided “as is” without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.
The information contained in this report is provided by Ridge Publishing Co. Inc. (Ridge). One of the principals of Ridge, Mr. David Moenning, is also President and majority shareholder of Heritage Capital Management, Inc. (HCM) a Chicago-based money management firm. HCM is registered as an investment adviser. HCM also serves as a sub-advisor to other investment advisory firms. Ridge is a publisher and has not registered as an investment adviser. Neither HCM nor Ridge is registered as a broker-dealer.
Employees and affiliates of HCM and Ridge may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Editors will indicate whether they or HCM has a position in stocks or other securities mentioned in any publication. The disclosures will be accurate as of the time of publication and may change thereafter without notice.
Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.