QUALIPORT
Befriend the Dependable Dividend!

By Maynard Paton (TMFMayn)
April 26, 2001

Rochester, Kent – There are many ways to place a "fair value" upon a company. I prefer the traditional shorthand valuation methods, such as the price to earnings (P/E) ratio, the price to sales (PSR) ratio, the price to book (PBV) ratio and the price to earnings growth (PEG) ratio.

(And beware; there are also a handful of esoteric shorthand ratios that exist too, such as the very Wise EV/EBITDA. My tip is to steer clear of any valuation acronym that has more than three letters.) 

However, if I had to rely on just one valuation ratio, it would be the simple dividend yield. I have three reasons:

1) Dividend yields have ready-made benchmarks in the form of other non-equity sources of investment, notably government bonds (gilts) or ordinary deposit accounts. Simply, if a company has a prospective dividend yield significantly greater than the risk-free returns elsewhere, then you could be onto an investment bargain.

2) Ongoing dividend payments tend to be more reliable and predictable than a company's profits or turnover. If trading takes a nosedive, most companies, larger ones especially, will do their best to maintain or even increase their dividend.

A good example of the predictable dividend phenomenon comes from British Airways (LSE: BAY). Here's its record since 1992:

Year    Earnings per share     Dividend per share 
              (p)                   (p)

1992         28.5                   9.8
1993         22.1                  10.2
1994         28.3                  11.1
1995         36.5                  12.4
1996         42.7                  13.7
1997         49.2                  15.1
1998         27.1                  16.6
1999         14.7                  17.9
2000        (24.9)                 17.9

3) Dividends are fact. They are cash in your bank. Unlike a company's turnover, assets, cash flows or profits, dividend payments are not clouded by any accounting subjectivity.

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But how does the dividend payout fit into the Qualiport investment philosophy?

The ultimate aim for any Qualiport investment is for it to beat the stock market. With the stock market returning an average of around 11-12% since 1918, our ambition is to generate an annual average return of 15%. But to get that 15% annual return for five years, you don't have to find a company that could improve its profits by 15% over that time.

More and more, I'm of the opinion that long-term investors should find a middle ground between "fast growers" and "high yielders". A sort of "medium grower with a medium yield", if you like. In my mind, the ideal company would have the potential to increase its profits 10% per annum, while offering a 5% dividend yield. If the share price ran in tandem with the company's earnings, then a 15% annual return would be generated.

But for a share price to run in tandem with earnings, the company's P/E must remain constant over time. If the P/E declines, as so often happens with fast growing companies, the investment return falters too. However, with such "medium" investments, the stock market does investors a favour. With most attention firmly directed upon earnings growth rates, the P/Es associated with "medium" growers are at levels much less prone to severe de-ratings. So much so that investors effectively get the dividend thrown in for free.

As John Neff writes: "I never quite understood why a 15 percent grower with a 1 percent dividend yield sold at twice the P/E ratio of an 11 percent grower with a five percent dividend yield."

He's (almost!) right, you know. For instance, PizzaExpress (LSE: PIZ), with its 15%-plus earnings growth rate and 1% dividend yield, presently sits on a P/E of 20. Halma (LSE: HLMA), on the other hand, with its 10% earnings growth rate and 4% yield, sits on a P/E of 13. Of the two, Halma instinctively looks the better bet at present. Indeed, even if Halma's shares went nowhere for the next five years, at least its dividends would equal the performance of a savings account (And with current stock market conditions, that would be quite an achievement!).

While the "medium grower with a medium yield" philosophy doesn't entirely eradicate the perils of relying on future earnings growth, it does further reduce the investment downside. In terms of valuation and our investment returns, far more Qualiport attention will be given to the trusty dividend in future. As I outlined earlier, the dividend is one of the more dependable friends for those embarking on stock market success.

More: Why Dividends Are Important Over the Long Run | The Fool's Guide to Dividends