As a part of the new Dividend Growth Stock of the Month series, Daily Trade Alert’s publishers and I agreed to supplement the regular articles with occasional observations about related topics. One topic that we both feel is important is overvaluation.
In Dividend Growth Investing Lesson 11: Valuation, we learned that overvaluation means that a stock is selling for more than it is worth.
In other words, in order to buy it, you have to pay too much.
The concept of valuation or “fair value” recognizes that there can be a significant difference between the quality of a company compared to the economic value of its stock.
An excellent company can have its price bid too high. Reasons vary.
Investors may be exuberantly chasing a “hot” company, or perhaps they emotionally overpay when chasing yield.
Those kinds of things happen in markets.
• Over the long term, you are setting yourself up for disappointing performance if you buy overvalued stocks. When the exuberance sinks back to a more rational attitude, the company’s price may stagnate or fall backwards. If you pay too much, you are setting yourself up for losses that you could have avoided.
• When you overpay for a dividend growth company, you are not getting as much yield as you ought to get. Higher yields from that company have been available in the past, and they probably will be available in the future. You only need to be willing to wait before jumping in.
Dividend Champions are companies that have raised their dividends for 25 years in a row or more. Their names come up a lot when the discussion turns to dividend growth investing. Currently there are 106 Champions.
Unfortunately, many of them are overvalued right now. At the end of this article is a heat map showing those that are most overvalued.
Here is how I spot which ones are in the danger zone.
1. I use FASTGraphs in two ways. First, I display the usual forward-looking graph and observe which channel the current price falls into.
Air Products and Chemicals (APD) is a fine company. It has low debt and an A credit rating. Its earnings are expected to grow at a rate of 13% per year for the next few years.
But look at its price (black line). It is selling at a P/E (price-to-earnings) ratio of 25.2, compared to a historical market value of 15. It is far above the highest channel shown on the graph. In other words, it is way overvalued. On a 5-point scale of valuation desirability, I give it the lowest score, which is 1.
2. I then reset the same graph to value APD at its “normal” P/E ratio, which is its average P/E ratio over the all the years that are available in the FASTGraphs database.
The picture improves, but not much. It turns out that APD’s average historical P/E ratio is 17.6. That makes its current price look a little closer to fair value (shown on this graph as the dark blue line). The price line is in the 5th channel above the fair value line.
Its fair value is a little over $100, but its price is above $150 per share. By this measure, APD is 50% overvalued. I again give it the lowest score on the 5-point scale. It gets 1 point.
3. I check Morningstar. Their star ranking stands for their estimate of each stock’s valuation. They use a different assessment method from FASTGraphs. They use a complex Net Present Value (NPV) approach. Some investors consider this approach to be the gold standard in valuing stocks.
They give APD two stars on a 5-star scale. Not as dire as the two FASTGraphs valuations, but still overvalued. In fact, Morningstar thinks that APD’s price is 20% too high. Morningstar’s 2 stars equals the stock’s score on our 5-point scale: 2 points.
4. Finally, I compare each stock’s current yield to its historical yield. This is a different approach to valuation. The idea is that over long periods of time, the market will tend to price a stock so that its yield stays within a typical range for that stock. The closer you are to the top of this range (i.e., the higher the yield), the more desirable is the stock’s valuation. If the yield falls toward the bottom of the historical range, it is likely that the stock is overvalued.
History suggests that you will be able to get it at a better yield if and when the price normalizes, or reverts to the mean for that stock.
This is an eyeball test covering the past 10 years. What do you think? I think that APD’s yield right now is beneath the middle of its 10-year average. On the 5-point scale, I would give it a 2. Its yield has certainly been higher, and it has rarely been lower than it is right now.
After I do the four steps above, I average the scores. APD performs miserably. It gets 6 points total. Its average score is 1.5. The market has simply run up its price far too high.
You can see that on this graph that goes all the way back to 1996. Using either the orange line (P/E = 15) or blue line (“normal” P/E for this company = 17.5) to represent fair value, you can see that APD has never been overvalued any more than it is now.
I would never buy APD at this price. You are just betting against the odds if you pay so much over fair value for a stock. It doesn’t matter how good APD the company is, it is simply not worth its sticker price right now.
Here is the scoring system that I use for valuation.
The worst average score that a stock can have is 1. In the APD example, its average score is 1.5, meaning that it is about as poorly valued as it can get at the moment.
The following table shows all of the Dividend Champions that have average valuation scores of 2.5 or worse. Unfortunately, at the moment, there are a lot of them.
But I would counsel patience. Markets go up and down, and individual stocks go up and down within the market. There are a few bargains to be had right now, and at some time in the future, there will be more.
That said, these are the Dividend Champions that I would not buy at the current time, based on their significant overvaluation. Many of these are great companies, but now is just not the time to buy their stocks.
(In the table below, a white cell means that there is no data available. That factor does not count in the scoring.)
— Dave Van Knapp
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