This is the first in a monthly series for Daily Trade Alert called Dividend Growth Stock of the Month. In this series, we will take a look at solid dividend growth companies that you might want to consider for your own portfolio.
The Wide Variety of Dividend Growth Stocks
One thing you have probably discovered about dividend growth stocks is that they come in all shapes and sizes. They can be found in almost every industry and in companies large and small.
In this series, we will look at a variety of “genres” of dividend growth stocks.
Two essential characteristics that dividend growth stocks have are yield and dividend growth rate.
That is, they pay dividends (their yields are not zero), and they grow the dividend payouts regularly.
You will see debates about which factor – yield or growth rate – is better, but in the abstract neither is better without additional context.
How important each one is to you depends upon your goals, age, stage of life, and so on.
Yield tells you how much money the dividend is as a percentage of the stock’s price. If you buy a stock for $100 and it pays $4 in dividends, it has a 4% yield. Yields in the 3.5% to 4% range are typical in the world of dividend growth investing, but yields from near-zero to double-digits are available.
Dividend growth rate, on the other hand, tells you how fast the dividend is growing per year. In the example above, if the company raises its dividend to $4.32 next year, its dividend growth rate (or DGR) was 8% that year. $4.00 + 8% = $4.32.
Many dividend growth stocks with higher yields tend to have low dividend growth rates. AT&T (T), this month’s Dividend Growth Stock of the Month, is an example. Its genre might be described as high-yield, slow-growth.
AT&T’s Dividend Characteristics
What jumps out at you?
- At 5.6%, AT&T has a high yield. The yield of the average Dividend Champion (stocks that have increased their dividend for at least 25 years in a row) is 2.5%. AT&T’s yield is 2.2 times the average.
- On the other hand, at 2.2% growth this year and 2.3% per year over the past 5 years, AT&T’s dividend growth rate is low. A typical Champion has a DGR of about 7% per year. AT&T’s DGR is about 1/3 the average.
So from a pure dividend perspective, AT&T offers a clear tradeoff: You get a much higher yield to begin with, but the dividend has been growing pretty slowly. Whether you like that tradeoff is purely up to you. No one else can tell you whether AT&T is “better” for you than, say a stock with a lower yield (like 2.5%) but a faster growth rate (like 8% per year).
My goal is to achieve a rising income stream from high-quality, low-risk companies. Is AT&T such a company?
I think it is. Let’s look at some fundamental information about AT&T.
As we all know, AT&T is “Ma Bell,” the largest telecommunications company in the world, with total sales just a little ahead of Verizon (VZ). We’ll talk more about AT&T’s business later. Let’s go through these numbers first.
AT&T’s ROE (return on equity) is 19%. ROE is a measure of efficiency. It is a standard metric used in judging stocks. It tells you how effectively the company uses shareholders’ capital to generate profits. (You will find a fuller definition of ROE in the notes at the end of the article.) AT&T’s ROE of 19% is quite good, better than average among all companies.
AT&T uses quite a bit of debt to finance its operations. Its D/E ratio of 0.8 is about average among all companies and low for a telecom company. For comparison, Verizon’s D/E ratio is 8 times higher (worse) than AT&T’s. There is nothing scary about a D/E ratio of 0.8.
The estimated earnings growth rate comes from analysts covering the company. The expected growth rate of 5% per year makes T a slow-growth company. It is growing, but not very quickly.
Besides looking at financial metrics, another way to judge a company’s quality is to see what ratings agencies and analysts say about it. S&P gives T a credit rating of A-. S&P explains that any rating of BBB+ is considered “investment grade,” so T’s rating is good. I usually invest only in “investment grade” stocks.
S&P also has a quality rating of B+ on the company. That is considered average. (The quality rating is explained in the notes at the end of the article.) For comparison, Verizon’s quality rating is B.
AT&T’s Story: How Does It Make Money?
When you are considering investing, there is more to think about than numbers. It is essential to understand a company’s business model. Many investors buy stock in companies that they know nothing about. Please don’t do that. I am never embarrassed to say that I don’t understand a company and therefore will not invest in it.
What I call the company’s Story describes the company’s business operations from the point of view of a potential investor. What makes you think it is a high quality company and that its stock is a good place to invest your money? Figuring out the company’s Story helps to answer those questions.
AT&T’s basic business is easy enough to understand. It is a modern national phone company, which these days means that it provides wireless and wireline phone, data, and Internet services.
Wireless: T is the country’s second-largest wireless provider, pulling in slightly less revenue than Verizon. You have seen the TV ads from both companies in which they tout their advantages over the other. The level of industry competition is high, but between them, Verizon and AT&T dwarf the rest of the competition.
T’s wireless business generates about half of its revenue. AT&T and Verizon have significant scale advantages against smaller cellular providers. T has invested heavily in increasing not only its physical network facilities but also in improved customer service. The company has been able to invest significantly in its network while simultaneously gaining market share and improving profitability.
It is difficult for smaller competitors such as T-Mobile or Sprint to engage in drawn-out price wars while still investing enough to continue to provide quality service. AT&T and Verizon have scale advantages that allow them to invest aggressively in networks, marketing, and customer service. At the current time, the price competition is putting pressure on profit margins across the industry, but in the long run, it is difficult to see how Sprint or T-Mobile can win a price war against T and VZ.
Wireline: AT&T is also the local phone company in 22 states. It provides phone service to about 27 million lines. Of course, the wireline phone business is slowly going away, and the company is transitioning through that change. A few days ago, it announced that it is writing off millions of dollars’ worth of copper wire.
Other business lines: AT&T services 17 million Internet users and 6 million television customers. It provides phone and data services (including Web hosting) to businesses nationwide.
The company has had an agreement pending since May, 2014 to acquire DirecTV for roughly $65 billion. If and when the acquisition is complete (expected in 2015, but these deals are never over until they are over), it will not only add to T’s size and growth, but it will also make content available that the company will undoubtedly try to leverage in various ways for further growth.
I usually grade each company’s Story. I give AT&T’s Story an above-average grade, based on its scale in wireless and ability to invest heavily to maintain and increase its advantages. The DirecTV acquisition is a wild card at this point, difficult to evaluate one way or the other.
Once you have determined that a company has dividend characteristics that you like, and that it is a high quality operation with sustainable economics, the final step is to value its stock.
I described how I value stocks in Dividend Growth Investing Lesson 11: Valuation. The idea is to interpret how a stock’s actual price compares to what it “ought” to be based on its current financials and growth outlook.
I use the FASTGraphs service in valuations. I like the way that their graphs plot valuation and actual price on the same graph. It makes valuation easy to understand.
I look at two FASTGraph valuations. The first is the default valuation, which usually uses a P/E (price-to-earnings) ratio of 15. That is the historical long-term P/E ratio of the market as a whole.
We see from this graph that T is undervalued – the stock is worth more than the price it is selling for. The orange line is the “fair value” line drawn at P/E = 15. The black line is the actual price. The actual price is a little more than 10% under the orange fair value line.
The second FASTGraphs valuation looks at “fair value” being defined by the stock’s long-term average P/E ratio. Lots of stocks normally trade above or below 15.
In the case of T, the two valuations are only slightly different. T’s normal P/E ratio over the past 14 years has been 14.2. But that difference is enough to draw the black price line closer to the fair value line (dark blue), and so the valuation measured this way is fair.
I also look at Morningstar. Their stars are a measure of their own valuation calculation. They use a different approach from FASTGraphs, and the two methods serve as a reality check on each other.
Morningstar gives AT&T 3 stars, which means fairly valued.
One last thing that I look at is the stock’s current yield compared to its historical yield. All else equal, I would rather invest in a stock that is yielding as much as it usually yields. That suggests that the market is pricing the stock at a usual valuation in regard to its dividend. A higher yield is even better. One way to make the comparison is from Morningstar’s “Current Valuation” display.
In this graphic, note the second-last line. It says that T’s 5-year average yield is 5.4%, and we know that its current yield is 5.6%. (Ignore the slight difference between Morningsta’s statement of T’s current yield at 5.5% and our other sources that say 5.6%.) Since these figures are so close, T is fairly valued by this reckoning.
Here is a summary of these four ways of assessing T’s valuation.
The overall conclusion is that AT&T is fairly valued at its current price of around $33.50.
There are a couple of factors that I like to look at that do not fall neatly into any of the earlier categories.
Beta is a measure of a stock’s relative volatility to the market as a whole. Most dividend growth investors like to own stocks with low price volatility, because then you are less likely to become emotional about the stock. Emotionalism often leads to bad decisions, such as panic-selling.
AT&T’s beta is 0.86, which means that it is 86% as volatile as the market and tends to move in the same direction. So if the S&P 500 rises 1% in a week or a month, T is likely to rise 0.86%. On the other hand, if the S&P 500 plunges 10% in a month (known as a “correction”), T is likely to drop only 8.6%.
Analysts’ recommendations are a mixed bag. They take into account each analyst’s business outlook, earnings estimates, valuation estimates, and other things that we have already covered. Most analysts and too many investors are obsessed with price changes, which as dividend growth investors we are less concerned about. Few analysts pay much attention to dividend growth, which is our main focus.
Nevertheless, I like to see what the consensus ratings are, if for no other reason then to see if there are red flags that I somehow overlooked. As you can see, lots of analysts cover AT&T, and overall they consider it OK right now.
I think AT&T is better than OK. I think it is a terrific stock for dividend growth investors that are happy with its high yield and slow but steady growth. I would like to be able to buy it at a better valuation, but even at today’s price, it yields almost 6%, which is more than three times the yield of a 10-year Treasury.
That is why I added shares of AT&T to my Dividend Growth Portfolio earlier this month. That purchase was described in this article.
Return on Equity: ROE is a widely used measure of management’s effectiveness. ROE is expressed as a percentage, and the formula is ROE = Net Income / Shareholder’s Equity. ROE provides insight into how much profit a company generates for each dollar that common shareholders have invested in the company.
All else equal, a higher ROE is better than a lower one. A higher ROE means that more profits are available to be invested to improve the business without the owners (stockholders) needing to inject more capital.
One caution: ROE can be juiced by other sources of capital besides what shareholders have invested, in particular by debt. So ROE should be interpreted in light of the company’s debt. A high ROE with little or no debt is better than the same ROE with lots of debt.As we saw earlier, T has an average level of debt.
You do not have to compute the formula yourself, as ROEs are widely available on the Internet. An ROE of 11%-12% is usually considered about average, and an ROE above 14%-15% is good. I also value consistency, so an ROE that is consistently 14% or above deserves extra credit compared to one that hops around from low to high and back again.
S&P Capital IQ Quality Ranking: Per S&P, this is a ranking of earnings and dividend quality that takes into account the growth and stability of earnings and dividends. Their grading ladder is as follows:
A+ : Highest ranking
A : High
A- : Above average
B+ : Average
B : Below average
B- : Lower
C : Lowest
D : In reorganization
Different Data from Different Sources: You may have noticed slight variations in the data used in this article. I pointed out, for example, the difference between AT&T’s yield of 5.5% vs. 5.6% depending on source.
Usually such discrepancies are slight and can be ignored, as I ignored the slight variation in yield. Over time, you will learn which sources can be trusted. My favorite sources include the Dividend Champions document for all dividend-related statistics; Morningstar for most fundamentals and ratios (such as the Debt/Equity ratio); FASTGraphs for P/E-based valuations and forward estimates; Morningstar for net-present-value (NPV) valuations; and S&P Capital IQ for miscellaneous figures.
— Dave Van Knapp[ad#wyatt-income]