Companies with decent average dividend yields and reasonable payout ratios are thought of as reliable and safe investments that offer income as well as an opportunity for capital growth. The dividend growth model reflects how a company has performed in the past.

Since it is just an indicator of past performance, it will not guarantee how a company will do in the future. However, we can only use the information that we have to make an informed investment decision. So, in making an investment, the dividend growth model is a very useful tool for the construction of your portfolio of investments that seek to provide a growing income stream. However, it is not the be all and end all of due diligence that should be performed on a company.

To calculate how much a stock is worth based on the dividend growth model, you will need these three things:

1.)    Current dividend payout of the company

2.)    Growth rate of the dividend

3.)    Your required rate of return.

The current dividend payout and growth rate of a company can be researched online. I like to use Reuters as they display a lot of dividend information along with the other necessary financial information.

Your required rate of return is based on personal requirements for return on your investment capital.

How To Calculate Value Based On The Dividend Growth Model:

1. Add 1 to the dividend growth rate. For example, if the rate is 12%, add 1 to 0.12.
2. Multiply the sum with the current dividend payout. For example, if the payout is $1.50, multiply that by 1.12 to get 1.68.
3. Divide the product, 1.68, by your rate of return less the dividend growth. For example, if your rate if return is 20%, less dividend growth rate of 12% is 8%. Divide 1.68 by 8% or 0.08 and you get $21.

The above example values the stock at $21 based on a 12% dividend growth rate. Compare this value to the most recent closing price of the stock you’re considering. If the closing price is lower, then the model has indicated that this stock has met your criteria and is worthy of further consideration.   

The dividend growth model relies on variables that can change over time and, as such, can only calculate how the stock should be valued at the current dividend growth rate. As we have discovered from the most recent market downturn, dividends do not grow at a constant rate in perpetuity, so the value that we calculate using the dividend growth model can change!

Of course, as with any valuation model, there are risks associated with investing based on purely the dividend growth model. It does, however, provide a good data point for your investment analysis.

To know if the dividend growth rate growth can be sustained for many years, one can also evaluate the sales growth and profit margin trends. As market conditions change, it is useful to continue to run potential investments through the dividend growth model, accounting for changes in dividend growth rate and the dividend payout.

Of course, the situation in Greece has been front page news this week and it has created some choppy waters for investors (it was another volatile day on the markets yesterday – but that was apparently caused by a trading error). Amid the headlines, and the increased market volatility, we thought it might be helpful to take a look at how the sovereign debt situation has evolved and why it is causing so much noise (and by extension, investor anxiety).

Each day, there seems to be a new take on the story and many of the headlines have been conflicting. For example, consider the following:

• Two EU Ministers: No Bailout for Greece – Wall Street Journal (Jan 18)
• Merkel Says Greece Doesn’t Need Financial Support – Dow Jones (Mar 22)
• Fears rise that Greece is days from defaulting – Associated Press (Apr 12)
• Greece begins talks on details of IMF aid deal – Reuters (Apr 22)
• EU: Greece loan package coming soon but worries persist – Globe (Apr 30)
• Greece swallows tough medicine in bailout – Globe (May 3)
• Analysts like Greek bank despite nation’s woes – Bloomberg (May 4)

However, as is often the case when it comes to complex issues, there’s usually more to the story than meets the eye. The situation in Europe is complicated and very volatile and many investment management teams are monitoring new developments closely.

Also, amid the noise, it should be noted that there have been other developments that, while not front page news, are noteworthy nonetheless from an investment standpoint.

For example, the U.S. dollar has strengthened which has benefited U.S. dollar denominated investments, and global bond spreads have widened, creating potential investment opportunities.

Another important note is that many of our favorite dividend growth stocks have returned to profitability. Regardless of the happenings in the world economy, when our dividend growth stocks are making money, we will be rewarded accordingly… But, it will take faith in our philosophy and time for the markets to catch up to us .

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The following are three high-level economic data points that we can use, along with our other tools, to further assist us determining our views on equity market investments.

1.) U.S. Housing

As the root of the credit crisis, healing in the U.S. housing market is a precondition for sustainable recovery. Recent data has confirmed that the worst is behind us and the residential real estate market is stabilizing.

The inventory of unsold houses while still high is heading in the right direction towards clearing and sales of existing homes have recently turned positive on a year-over-year basis. And an index which measures year-over-year price changes of houses in 20 major U.S. cities (the S&P/Case-Shiller Home Price Index) plunged 33.6% from its June 2006 peak to the April 2009 trough, but has now climbed 1.9% over the past two months.

2.) The U.S. Consumer

The resurgence of the U.S. consumer will be key to watch as recovery unfolds since consumption is 70% of the American economy. Despite the ‘hit’ that the housing crisis has exacted on their net worth, American household balance sheets are still in relatively better shape than they’ve been in the past due to the tremendous growth net worth over the last decade.

However, the process of deleveraging (winding down debt) has begun and this will impact spending patterns in the near-term.

3.) The U.S. Manufacturing

The level of manufacturing has historically followed an inverse path to the Fed funds rate but on a 6-month lagged basis – as the fed funds rate drops, six months later, manufacturing activity picks up.

However, in fall 2008, although rates declined to historically low rates, the credit crunch intensified and that typical relationship between low interest rates and increased manufacturing activity did not materialize. More recently, credit channels have opened up and the ISM (gauge of manufacturing activity) has improved, indicating the economy is finally responding to massive stimulus after a long lag.

And further improvement just yesterday with the latest ISM level better than expected at 52.9 – the first reading above 50 since January 2008 and hit the highest level since June 2007. This is further indication that while not yet normal, the economic environment is normalizing.

These are three key areas of the market to watch when assessing the high-level economic situation and it’s relationship to the stock market trends and valuations.

Of course this isn’t the be all and end all of data you should include in your due diligence, but it certainly plays a role as you calculate your risk tolerance moving forward.

Here’s a summary of market action and key developments from last month, including monthly benchmarks.

• Investors saw more data indicating that healing is underway in the global economy. Increased optimism paved the way for a fifth consecutive month of gains across world markets.
• International stocks advanced. The MSCI World Index returned 8.4% (in $US terms). Since March 9th, the MSCI Asia Index has risen about 58% in local currency terms.
• Commodity prices rose. Copper is up more than 80% year-to-date supported by increased demand from China. The S&P/TSX Composite Index benefited, adding 4%. The S&P/TSX has climbed 45% since hitting a five-year low on March 9th.
• In the U.S., stocks made up more ground. The Dow Jones Industrial Average (DJIA) had its best month since 2002, up 8.6% . The S&P 500 Index advanced for the fifth consecutive month (the longest streak since 2007) gaining 7.6% . The S&P 500 is now up more than 40% since March 9th and Monday, it closed above the 1,000 level for the first time since November 2008.
• Volatility continued to be a key theme in currency markets. After falling more than 6% against the U.S. dollar in June, the Canadian dollar appreciated by 7.4% versus its U.S. counterpart in July. This cut into returns on investments denominated in $US. Case in point, the 7.4% gain on the S&P 500 was essentially wiped out when converted back to C$.

With much of the latest economic news continuing to look less bad (over 70% of companies beat expectations last quarter and it appears US housing may have found a bottom), the economy looks to be on the mend.
However, we must realize that the rate of recovery that we are seeing is not normal and likely cannot be maintained long-term. That said, as an investor looking out 5+ years I belive valuations in the equity market are still low and the potential remains for double-digit returns heading forward over a 5+ year horizon.

Black Friday

Black Friday is so named because it’s the day that retailers finally move into “the black” for the year and it’s the day that marks the unofficial beginning of Holiday shopping. It’s also the busiest day of the year for most retailers in the U.S. and a day that many items go on sale as businesses compete for those gift shopping dollars. Seasoned shoppers will do their research by scouring through local papers then line-up early in order to get the best deals – after all, if you can get the same item at a lower price, why wouldn’t you?

Strangely, when it comes to investing it seems that people want to pay more. Mutual fund sales show this time and time again. When markets are close to their peaks, mutual fund sales are strong, but when markets are close to their bottoms, mutual fund sales are weak. But who can blame investors? If we look at markets in the U.S., the S&P 500 Index is currently at levels similar to 10 years ago and while Canadian markets have faired somewhat better, it’s still been an ugly 10 years.

A Lesson In History

In 1974 the S&P 500 Index dropped from a closing value of 99.74 on March 13 down to a closing value of 62.28 on October 3 losing over 37% of its value (note that the index is based on price only and does not include dividends). And much like today, there were several events that were weighing on the minds of investors, such as:

1. The energy crisis following the OPEC oil embargo
2. The resignation of President Richard Nixon following the Watergate scandal
3. The loss of Vietnam war
4. An economy in recession

What investor would want to be in the market at a time like that?

Well, as it turns out, a very astute one. The table below shows the returns of the S&P 500 Index following October 1, 1974.

S&P 500 Index

The most important thing an investor can do right now is to learn from history. Although there are some differences between any two periods of time, there are examples of times in the past with many similarities to what we are seeing today.

Those past times represented outstanding investment opportunities in equity markets. No one knows exactly when the market will be at its bottom, but if you’re buying right now, you know for fact that it’s not at its peak. And, like many consumer goods, the market is on sale.