I do my due diligence with every stock I purchase, which includes performing fundamental analysis, evaluating qualitative aspects (like competitive advantages), assessing risk, and estimating intrinsic value.
It’s that last part that is particularly important.
Price is what you’ll pay for a stock, but it’s value that you end up getting in exchange for your money. The latter gives context to the former; without knowing the latter, the former is practically meaningless.
And when investing in dividend growth stocks, you should always aim to buy high-quality dividend growth stocks that appear to be undervalued at the time of investment.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk.
These advantageous dynamics are relative to what the same stock might otherwise offer if it were fairly valued or overvalued.
The higher yield plays out due to the inverse correlation between price and yield; all else equal, a lower price will result in a higher yield.
That higher yield goes on to positively impact total return, because total return is comprised of investment income (dividends or distributions) and capital gain (stock price appreciation).
Well, you can see right off the bat that you’re looking at greater long-term total return potential due to the additional investment income that a higher yield provides.
Furthermore, the capital gain component is given a boost via the “upside” that exists between price and value.
If you pay a price that’s well below estimated intrinsic value, you’re looking at the potential for additional capital gain if/when the stock market more accurately prices your stock investment.
While the market isn’t necessarily good at accurately pricing stocks over the short term, price and value do tend to more closely correlate with one another over the long run.
And that upside is on top of whatever capital gain you’d naturally be looking at as a company becomes worth more over time (as it increases its profit).
This all has a way of translating into less risk.
You introduce a margin of safety when you pay less than estimated intrinsic value.
Because a valuation is always an estimation, you want to err on the side of caution.
And a margin of safety protects you against ending up with an investment that’s worth less than you paid, just in case the investment thesis goes wrong through any variety of ways (management missteps, new competition, unforeseen events, etc.).
Of course, it’s also just plain better to risk less capital, either on a per-share basis or across the total transaction (buying a fixed number of shares).
Fortunately, these advantageous dynamics aren’t impossible – or even all that difficult – to spot.
Fellow contributor Dave Van Knapp made that “spotting” process even easier by divulging a great valuation system that can be more or less applied to just about any dividend growth stock out there.
That system is part of an overarching series of articles on the dividend growth investing series as a whole; he refers to these articles as individual “lessons”.
The lesson that focuses on valuation specifically is Lesson 11: Valuation.
I perform fundamental analysis, look at competitive advantages, assess risks, and value a stock.
Then I share my findings with the investment community through the Undervalued Dividend Growth Stock of the Week series.
The resources I’ve laid out above might be free, but they’re actually worth a lot of money.
It’s up to you to put these resources to work though and to get started.
I wish you luck and success.