Caution: This Dividend Growth Stock Appears 17% Overvalued

Lately, I’ve been watching the stock market become more volatile by the day.

That can be pretty scary when we’re talking about money seemingly vanish right in front of our very eyes.

But the money isn’t really going anywhere at all.

Prices of stocks naturally fluctuate all the time. If that’s not something you’re comfortable with, you probably shouldn’t be in stocks.

The money doesn’t really go anywhere until you commit to a transaction – buying or selling.

[ad#Google Adsense 336×280-IA]So you don’t really lose money unless you sell a stock for a lower price than you paid.

While volatility can be a little frightening, one defense an investor has against becoming underwater on stocks – even if you don’t plan on selling – is to insist on a margin of safety upfront by avoiding overvalued stocks.

Separating price and value is an extremely important skill to have if one is to succeed as a long-term investor.

Acquiring a margin of safety when buying a stock simply means you’re paying less than what a stock is likely worth.

Let’s say you analyze a stock and conclude that a reasonable estimate of its fair value is $100.

A margin of safety would be buying that stock at $80. That’s a 20% margin of safety under that $100 valuation. That means that even if your estimate is off a bit or the company doesn’t perform as expected, you can still end up okay.

Moreover, there’s the possibility for that $20 upside if the market realizes the discount and reprices shares.

Conversely, paying $120 for that stock only worth $100 means you’re putting yourself in trouble right away.

What if the company announces some type of unforeseen issue? What if the economy causes problems for its industry? What if your estimate was off and the stock is worth closer to $90? What if the stock market becomes volatile and drops that stock’s price quickly after your purchase?

You’re needlessly introducing doubt and downside. You’re risking an extra $20 per share for no reason.

That’s not a situation you want to find yourself in, obviously. You don’t want to overpay and spend $120 for a stock, only to quickly see it drop by 20% or 30%, which would be closer to what it’s worth.

That’s just one reason you want to avoid overvalued stocks.

But there are many other reasons.

I focus (and personally invest in) high-quality dividend growth stocks.

These are stocks that have measurable track records of rewarding shareholders with growing dividends over many years.

You can see more than 700 of them by checking out David Fish’s Dividend Champions, Contenders, and Challengers list.

Mr. Fish specializes in these stocks, tracking every US-listed stock with at least five consecutive years of dividend raises.

The reasons one would want to invest in these stocks should be fairly clear – high-quality businesses tend to outperform over the long run, and growing dividend income is an excellent source of completely passive income that should allow for increasing purchasing power over time.

But while I love collecting bigger dividend checks every year, I wouldn’t want to substantially overpay for any dividend growth stock.

That’s because my income is reduced, my income will compound slower, my long-term potential total return will be lower, and my risk is higher.

You can already see above the additional risk you take on when you buy an overvalued stock.

But you also see reduced income.

Price and yield, all else equal, are inversely correlated – as a stock’s price rises, its yield correspondingly drops. So paying more means a lower yield, which means less ongoing income in your pocket.

And since we’re talking about dividend growth stocks here, we have to keep in mind that the dividend growth you’ll experience is based off of the yield you locked in when you bought your stock.

While a company doesn’t care what you paid for its stock – its dividend raise will be based off of underlying company performance and ability to sustain that payment – a dividend increase is more effective when you lock in a higher yield, and certainly less effective when you pay a higher price and lock in a lower yield.

On top of all that, you risk the potential for a lower total return on your investment for as long as you hold it.

Yield is one component of total return, so locking in a lower yield already handicaps your total return from the outset.

And then there’s the interplay between overpaying and downside, as discussed above.

All in all, it’s pretty clear why you’d want to avoid overvalued stocks, even high-quality dividend growth stocks that are overvalued.

Fortunately, it’s not terribly difficult to ascertain a reasonable estimate of a stock’s intrinsic value so you can avoid these drawbacks.

If valuing stocks is something you need some help with, I’d definitely recommend checking out the stock lesson on valuation, put together by fellow contributor (and dividend growth investor) Dave Van Knapp. In fact, I’d recommend checking it out even if you’re familiar with valuing stocks.

This valuation tool is specifically designed for dividend growth stocks, so it’s a perfect companion to this article and Mr. Fish’s invaluable resource linked above.

In the spirit of avoiding overvalued dividend growth stocks, I’m going to discuss a stock that appears to be notably expensive right now. It’s arguably a really solid investment with a margin of safety present, but the current valuation doesn’t indicate one right now.

Waste Management, Inc. (WM) is a holding company that, through its subsidiaries, operates the largest integrated waste management services in the United States.

This is one of the oldest business models in existence, folks.

Technology changes. Retail is moving online. Even the energy space is undergoing a lot of turmoil.

But hauling trash isn’t something that radically changes all that much. And as long as people produce garbage (something very highly likely to continue), business should be good for Waste Management.

That all said, it’s not worth paying any price for.

Now, I wouldn’t have brought this stock up if it didn’t have a measurable track record for dividend growth.

With 13 consecutive years of dividend raises, this company continues to reward shareholders with growing cash flow year after year.

And the stock yields 3.14% right now, so there’s also plenty of current income.

However, that’s about 30 basis points lower than the five-year average yield of 3.5% for the stock. So one’s accepting a lower yield than what’s usually been available, on average, over the last five years. Good income but not as good as it could be.

That yield also isn’t terribly spectacular when one considers the somewhat middling dividend growth rate.

st wmOver the last decade, Waste Management has increased its dividend at an annual rate of 6.8%.

Not too shabby at all; however, the dividend growth has slowed as of late – the five-year dividend growth rate is only 4.1%. So there’s some clear deceleration here.

We likely see some of that deceleration due to a fairly high payout ratio of 70.4%.

Waste Management typically operates with a high payout ratio due to its utility-like stable cash flow. However, this is quite a bit higher than what it was a decade ago.

So there’s some things to like and not like with the dividend. Pretty solid track record, but a fairly high payout ratio will limit the potential for significant dividend growth moving forward. But I see this is a stable, defensive holding rather than something for big income growth.

We actually see that play out with the underlying growth in the business.

Looking at the top-line and bottom-line growth over the last decade will tell us a lot about the overall trajectory of the business. The prior decade includes the financial crisis and ensuing Great Recession; however, the exact reason why one would want to invest in a company like this is due to the stability.

Waste Management’s revenue increased from $13.074 billion to $13.996 billion from fiscal years 2005 to 2014. That’s a compound annual growth rate of 0.76%.

Certainly unimpressive, even for something defensive. There was a somewhat sizable dip during the Great Recession, indicating one should think carefully about the overall defensiveness of this investment.

Because of their exposure to hauling away trash for commercial clients, Waste Management will be exposed to larger domestic macroeconomic trends. Businesses that go bankrupt or let people go will naturally produce less waste.

The company’s earnings per share growth over the past decade was similarly unimpressive. EPS moved up from $2.09 to $2.79 – a CAGR of just 3.26%.

Again, you see a dip there. Somewhat secular but not really much growth.

The outsized profit growth (relative to revenue) was largely driven by share repurchases. The outstanding share count is down by about 18% over this stretch, which is a rather large reduction.

S&P Capital IQ anticipates this continuing to drive excess growth. The firm is forecasting 7% compound annual growth for Waste Management’s EPS over the next three years, citing repurchases. Indeed, Waste Management just recently announced a $1 billion buyback program.

So we can see dividend growth has definitely outstripped EPS growth over the last decade. This cannot continue on much longer, especially with that moderately high payout ratio. If S&P Capital IQ’s forecast is close, mid-single-digit dividend growth is possible for the foreseeable future. But I would temper my expectations.

Further tempering one’s enthusiasm about Waste Management, the balance sheet is stretched.

The long-term debt/equity ratio is 1.42 and the interest coverage ratio is below 5.

There’s just very limited flexibility here. That goes for both acquisitions and potentially funding any short-term gaps in dividend coverage.

Profitability is strong and very competitive, though. Waste Management’s size confers scale and cost advantages, and I think this shows up here.

The company’s net margin averaged 6.30% over the last five years; return on equity averaged 13.91%. Both numbers are strong, even considering the negative impact by a one-off year in FY 2013.

Overall, it’s a mixed picture for me. It’s certainly a business model that’s easy to understand and unlikely to dramatically change much over the foreseeable future. The yield is also quite appealing.

However, both profit and dividend growth hasn’t been outstanding as of late. A fairly high payout ratio will limit upside on dividend growth moving forward. And the balance sheet is in somewhat poor condition.

As an investor risking my money, I always want a margin of safety. I always want to limit my risk as much as possible while locking in the highest possible yield.

But I’m just not sure we’re looking at any margin of safety here…

The P/E ratio on the stock is sitting at 22.38. That’s awfully high for a stock growing in the very low single digits. The yield, as discussed, is much lower than its recent historical average. Moreover, metrics like price-to-book, price-to-sales, and price-to-cash flow are all significantly elevated off of their five-year averages.

Appears to be rather expensive for what you’re getting. What’s a reasonable estimate of its intrinsic value?

I valued shares using a dividend discount model analysis with a 10% discount rate and a 5.5% long-term dividend growth rate. That growth rate is a compromise between the 10-year and 5-year dividend growth rate, factoring in the higher payout ratio and forecast for better near-term EPS growth. Looking at all, I wouldn’t expect much more than that looking out over the long term. The DDM analysis gives me a fair value of $38.45.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today. I find it to be a fairly accurate way to value dividend growth stocks.

I think I was being very fair – if not aggressive – with the valuation model, and even then the stock is expensive. No margin of safety is readily apparent. For perspective, I’m not the only one who thinks this stock is expensive.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates WM as a 2-star stock, with a fair value estimate of $47.00.

S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ rates WM as a 4-star “buy”, with a fair value calculation of $43.40.

I’m not sure why the latter firm recommends a stock they feel is so vastly overvalued but so be it. Nonetheless, you can see a clear trend where the price is well above what the stock is likely worth. Averaging out the three valuations gives us a blended figure of $42.95. That would infer this stock is potentially 17% overvalued.

wmBottom line: Waste Management, Inc. (WM) is operating in an industry that rarely faces any kind of major changes, and the incumbents operate with significant competitive advantages. However, the growth has been lackluster, the payout ratio is rather high, and the company does face weakness in earnings when the economy hiccups. With no apparent margin of safety and the possibility for 17% downside on top of a yield that’s lower than its recent historical average, I’d avoid this stock.

— Jason Fieber