This is one of my all-time favorite Buffett quotes. In ten small words the entire philosophy of value investing is conveyed. The inherent message is that price and value aren't necessarily the same. This is how value investors make money in the stock market — buying stocks for less than their fair value.
When selecting dividend growth stocks, I take a value approach in determining the maximum price I can pay and still obtain my long-term target. The focus is on the investment's value derived from the future dividend stream generated by the stock.
Since I am looking at stocks differently than many other investors, I can often find value, as I have defined it, when others can not. Here is how I calculate Fair Value:
Fair Value PriceI use the Mid-2 Price and the NPV MMA Price when calculating the Fair Value Price of a stock. They are weighted depending on where we are in the cycle. Of the two, I consider NPV MMA Price the more important. We will look at how each is calculated below.
NPV MMA PriceThis approach considers two cash flows — one from a Money Market Account (MMA) earning a rate equal to a 20-year Treasury and a dividend growth stock. The value calculated is the net present value (NPV) of the difference between the annual dividend earnings of this investment and the interest income from the MMA over 20 years.
The NPV MMA target is determined based on the number of consecutive years of dividend increases. The formula is: Target = Base – (Years x Increment) + Minimum where Base=3,000, Increment=100, Minimum=500. Thus 0 years of dividend growth yields a $3,500 target and 30 years of growth yields a $500 target. The D4L-PreScreen.xls model can be used to calculate this number.
Mid-2 PriceThe Mid-2 Price is based on more traditional calculations. It considers four fair value calculations, Average High Yield Price, 20-Year DCF Price, Average P/E Price and Graham Number, the highest and lowest fair values are excluded and the remaining two calculations are averaged to calculate the Mid-2 Price.
The 20-Year DCF (Discounted Cash Flow) Price is calculated by taking the Net Present Value (NPV) of the next 20 years of dividends and the estimated value of the stock at the end of 20 years. See 20-Year-DCF.xls for an example of how this is calculated.
Average High Yield Price is calculated by dividing current dividend per share by the average high dividend yield price for each of the last five years (dividend per share divided by the year’s low share price).
Average P/E Price is calculated by multiplying the EPS (trailing twelve months) times the minimum of: 1.) five-year average of high and low P/Es or 2.) last year's high P/E.
The Graham Number Price is calculated by taking the square root of 22.5 times the tangible book value per share times EPS (lower of trailing twelve months or average last three years).
Benjamin Graham, Warren Buffett's mentor and the father of value investing, developed rules for the defensively screening stocks. This formula uses his principles to calculate the "maximum" price one should pay for the stock.
Graham believed, as a rule of thumb, the product of P/E ratio and price-to-book should not be more than 22.5 (P/E ratio of 15 x price-to-book value of 1.5). The 15 P/E was a result of Graham wanting his portfolio to have a yield equal yield to that of a AA bond (back then around 7.5%). The inverse of this yield is 1 divided by 7.5%. That works out to 13.3; he rounded up to 15.
Select Dividend Stock's Fair ValueI am currently weighting the Mid-2 price and NPV MMA price by taking the lessor of the two + lower of 1.) 30% increase or 2.) 75% of the difference between Mid-2 price and NPV MMA price. Below are several select stocks with along with their calculated Fair Value Price and % discount:
Walgreens Co. (WAG) | Yield: 1.6%
Fair Value: $44.41 | % Discount: 0.8%
Walgreens Co. is the largest US retail drug chain in terms of revenues. It operates more than 8,000 drug stores throughout the US and Puerto Rico.
Watsco Inc. (WSO) | Yield 3.3%
Fair Value: $69.29 | % Discount: 1.3%
Watsco Inc. is the largest US distributor of air-conditioning, heating and refrigeration equipment, and related products.
Microsoft Corporation (MSFT) | Yield: 2.4%
Fair Value: $27.38 | % Discount: 1.7%
Microsoft, the world's largest software company, develops PC software, including the Windows operating system and the Office application suite.
Colgate-Palmolive (CL) | Yield: 2.6%
Fair Value: $95.10 | % Discount: 7.0%
Colgate-Palmolive Company (Colgate) is a major consumer products company that markets oral, personal and household care, and pet nutrition products in more than 200 countries and territories.
Questar Corporation (STR) | Yield: 3.3%
Fair Value: $19.79 | % Discount: 8.9%
Questar Corp is engaged in gas transportation and storage, and retail gas distribution primarily in Utah. Its exploration and production unit was spun off in mid-2010.
The Clorox Company (CLX) | Yield: 3.2%
Fair Value: $74.92 | % Discount: 9.1%
The Clorox Company is a diversified producer of household cleaning, grocery, and specialty food products is also a leading producer of natural personal care products.
McDonald's Corporation (MCD) | Yield: 2.9%
Fair Value: $95.49 | % Discount: 10.4%
McDonald's Corporation is the largest fast-food restaurant company in the world, with about 32,500 restaurants in 117 countries.
Harleysville Group Inc. (HGIC) | Yield: 4.5%
Fair Value: $36.61 | % Discount: 12.6%
Harleysville Group Inc. underwrites a broad array of personal and commercial coverages. These insurance coverages are marketed primarily in the eastern and midwestern US.
Lowe's Companies Inc. (LOW) | Yield: 2.2%
Fair Value: $27.27 | % Discount: 13.4%
Lowe's Companies Inc. sells retail building materials and supplies, lumber, hardware and appliances through more than 1,700 stores in the US and Canada.
Lockheed Martin Corp. (LMT) | Yield: 3.7%
Fair Value: $93.50 | % Discount: 13.9%
Lockheed Martin Corp. is the world's largest military weapons manufacturer and is also a significant supplier to NASA and other non-defense government agencies receiving about 93% of its revenues from global defense sales.
Intel Corporation (INTC) | Yield: 3.4%
Fair Value: $28.47 | % Discount: 18.9%
Intel Corporation is the world's largest manufacturer of microprocessors, the central processing units of PCs, and also produces other semiconductor products.
Procter & Gamble (PG) | Yield: 3.0%
Fair Value: $80.22 | % Discount: 19.3%
The Procter & Gamble Company is a leading consumer products company that markets household and personal care products in more than 180 countries.
Target Corporation (TGT) | Yield: 2.2%
Fair Value: $65.03 | % Discount: 21.4%
Target Corp. operates operates about 1,500 Target and 250 SuperTarget general merchandise stores across the US.
Abbott Laboratories (ABT) | Yield: 3.5%
Fair Value: $68.81 | % Discount: 22.5%
Abbott Laboratories is a diversified life science company and is a leading maker of drugs, nutritional products, diabetes monitoring devices and diagnostics.
Walmart Stores Inc. (WMT) | Yield: 2.7%
Fair Value: $70.69 | % Discount: 23.5%
Walmart Stores Inc. is the largest retailer in North America and operates a chain of discount department stores, wholesale clubs, and combination discount stores and supermarkets.
Buying a quality stock below fair value is always a good thing. However, when we must choose between quality and valuation, always go with quality. Someone else realized this also...
It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
— Warren Buffett
If you make a mistake and pay too much for a great company, eventually time will correct that problem. The same can't be said for a poor or mediocre company.
Full Disclosure: Long CL, CLX, MCD, HGIC, LMT, INTC, PG, ABT, WMT. See a list of all my income holdings here.
- 10 Dividend Stocks Delivering A Quick Payback
- Where To Find Great Dividend Stocks
- 8 Dividend Stocks With Above Market Performance
- 7 Dividend Stocks For The Ultimate In Deferred Gratification
- Finding Low Risk Dividend Stocks
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