Introduction

We are in the seventh year of a strong bull market, and stock valuations have generally become extended as measured by the S&P 500.  It is undeniable that the overall market’s valuation today is higher than it has been in years.  However, even though that statement may be true in the general sense, it does not mean that every stock in the market is overvalued.  Nevertheless, there are many investors unwilling to invest in any common stocks simply because they believe the market is too high, even though there may be many individual stocks available at attractive valuations. 

This all-stocks-are-too-high attitude is even more pervasive when it comes to dividend growth stocks.  Many are arguing that because interest rates are so low, investors desirous of income have driven up the valuations of all blue-chip dividend growth stocks to dangerously high levels.  Although I will agree that this is in fact true for perhaps a majority of blue-chip dividend growth stocks, it is not true for all of them as I will illustrate later.

With this in mind, I conducted an extensive search of all prominent dividend growth stocks looking for value and attractive dividend yields.  I went through the entire CCC lists of Champions, Contenders and Challengers presented by fellow Seeking Alpha author David Fish, and screened the entire universe of more than 20,000 companies in the F.A.S.T. Graphs™ research tool universe.  My objective was to find 20 attractively-valued high-quality dividend growth stocks that could produce an average yield greater than 3% in the aggregate. Although attractive value and above-average yield was admittedly difficult to find, I was able to come up with my list of 20.

Principles of Sound Valuations on Common Stocks

Examining the same concept expressed in my introduction from a different perspective, rational investors recognize that all stocks do not move in tandem with the market.  This is especially true over the longer run.  In my experience I have an observed and learned that there are two primary forces that generate long-term returns on an individual stock (business).  The first and foremost driver of return is the level of operating success of the business behind the stock.  The second primary driver is the price or valuation you pay to buy the stock relative to its operating business success. 

A company’s operating success is typically reflected by its earnings growth rate per share over time.  In the same vein, valuation is often measured as a function of the multiple of earnings you pay to buy the company’s operating success.  The company’s earnings multiple is expressed as a P/E ratio which is simply the company’s price divided by its earnings.

However, the more important aspect of the P/E ratio is that it also serves as a quick and simple measurement of the return on your invested capital that a company’s total earnings provide when expressed as earnings yield.  This is also a simple calculation which is just the inverse of the P/E ratio. In order to determine a company’s earnings yield, you invert the formula and divide earnings by price (E/P = earnings yield).   A quicker and easier way to calculate earnings yield is to simply divide the number 1 by the P/E ratio.  For example, if you divide the number 1 by a P/E ratio of 15, you get an earnings yield of 6.67% rounded (1/15=6.67). 

Now, at this point it should be understood that calculating earnings yield does not simultaneously indicate that by investing as a shareholder/ partner in a company that you are entitled to all of its earnings.  Instead, earnings yield is a useful indication of whether or not the company’s earnings power is adequately compensating you for the risk you are taking in comparison to alternative investment options.

One method where this calculation becomes especially useful is as a measurement of the risk premium a stock offers in relation to prevailing risk free rates.  The most common risk free measurement is the 10-year T-bill.  The current rate on a 10-year T-bill is 2.23%.  Therefore, rational investors would expect a company to offer a risk premium earnings yield that is significantly higher than 2.23%.  This same logic would equally apply to evaluating the valuation of an index like the S&P 500 just as it does to an individual stock.

Another way to utilize the earnings yield in order to evaluate fair valuation is to compare it to the long-term average return that stocks have historically generated.  Depending on the timeframe being measured, the long-term average return on stocks is somewhere in the range of 6% to 8%.  Keep in mind that this is the average meaning that some stocks have historically done better and some stocks have done worse.

But more importantly, this indicates that it is no coincidence that the average P/E ratio of the S&P 500 has historically been approximately 15.  Consequently, as a general rule of thumb, and depending on a given company’s earnings growth potential and quality characteristics, a P/E ratio of 15 is a reasonable indication of fair or sound value.  Although this is not a perfect indicator of fair value, I have learned to trust a P/E ratio of 15 to be an objective indicator of sound value for most companies.

However, just as it is with all rules of thumb, there are rational exceptions or adjustments that can be made.  For example, it might be rational to pay a modest premium for impeccable quality.  Additionally, it might also be rational to accept a moderately higher valuation on a blue-chip dividend growth stock when its yield is attractive enough, coupled with a history of raising its dividend every year.  Furthermore, with interest rates as low as they are today, the spread between the risk premium on stocks versus risk free 10-year T-bonds may also be high enough to indicate a willingness to pay a modest premium valuation on stocks.

To summarize, a P/E ratio of 15 can serve as a reasonable valuation guide or reference.  However, it is not perfect, and therefore should not be thought of as an absolute.  Instead, I contend that it be thought of as a fair valuation reference or a first glance indication that fair valuation may be evident on a stock.  With a P/E ratio of 15 serving as a valuation baseline, appropriate adjustments can and should be made based on many other factors, such as the ones I discussed above.  But most importantly, the investor should be cognizant that a P/E ratio higher than 15 represents a lower earnings yield, and consequently the potential for earning a lower future total rate of return.  Of course, the opposite is also true.

The S&P 500 a Valuation Perspective

The blended P/E ratio of the S&P 500 Index is 17.6, therefore, clearly moderately higher than my baseline fair value P/E ratio of 15 previously discussed.  This clearly indicates overvaluation; however, I would argue that this does not indicate especially dangerous levels from a long-term perspective.  On the other hand, this would indicate the potential for a short-term correction of 15% or greater if the market was to move back to a fair value P/E ratio of 15.  This is vividly revealed and calculated on the earnings and price correlated graph on the S&P 500 below.

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However, if we take a slightly longer-term view out to calendar year-end 2017 and run a return calculation assuming a normal P/E ratio of 15 based on consensus analyst earnings estimates, we could see a positive total annual return in excess of 4%.  This is below the long-term average returns for the index, but it is at least positive.

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Taking a slightly more optimistic view, if we applied a historical normal P/E ratio of 16 as reflected in the long-term graph above, the S&P 500 index could generate a total annual rate of return of 6.83%.  This would be consistent with the long-term average return of the index.

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Regarding the accuracy of analysts’ earnings estimates on the S&P 500 index, the following analyst scorecard suggests we have a better than 70% chance that they might get it right.  The scorecard is based on analysts’ historical accuracy records when making forecasts one year forward and two years forward.  There is a 10% accepted margin for error on the one year forward estimates, and a 20% accepted margin for error on the two years forward estimates.

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Top 10 High-Quality Blue-Chip Dividend Growth Stocks with an Average Aggregate Yield of 3%

In this part 1 of this 2-part series I will present my top 10 blue-chip dividend growth stock research candidates in order of the highest S&P credit rating to the lowest.  All but 2 of these top 10 blue chips are currently available at my fair valuation baseline P/E ratio of 15 or lower.  When I cover them individually I will argue that the two exceptions, Johnson & Johnson and Procter & Gamble, could be considered worthy of a modest premium valuation. 

The average current dividend yield of this top 10 list is slightly in excess of 3%.  But more importantly, most of them are Dividend Champions or Aristocrats with long histories of increasing their dividends every year.  In each specific example, I will present calculations of potential future total returns on the same basis that I did with the S&P 500 index above.

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Johnson & Johnson (JNJ)

Johnson & Johnson with its AAA credit rating and low debt-to-capital ratio is arguably the highest quality dividend growth stock on the planet.  Although it’s blended P/E ratio at 16.5 is moderately above my baseline valuation reference, I believe the company is worthy of this modest premium especially considering its current yield of 3%.

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On the other hand, when you pay a premium for quality, you must simultaneously be prepared to accept a lower rate of return as a result.  The following rate of return calculation based on consensus estimates would indicate a 5% annual total return through investing in Johnson & Johnson out to 2017.  It should be noted that the majority of this return would be supplied by Johnson & Johnson’s expected total cumulative dividends.  Consequently, I offer Johnson & Johnson as a safe research candidate offering above-average yield.

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Regarding analyst estimates, the following analyst scorecard indicates a perfect record on this bluest of blue-chips dividend growth stock.  Consequently, I offer the expectations of the above calculated total annual return with high confidence.

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Wal-Mart Stores Inc. (WMT)

High-quality dividend growth stock Wal-Mart Stores Inc. has fallen over 14% since the beginning of the year as a result of recent earnings weakness.  This brings it comfortably down to my baseline fair valuation level.

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Wal-Mart’s earnings are expected to recover next year and the following two years thereafter.  Assuming a fair value P/E ratio of 15 based on consensus earnings estimates out to 2017 indicates a  total annual rate of return in excess of 7%.

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The analyst scorecard on Wal-Mart is almost as impressive as what we saw with Johnson & Johnson.  However, it should be noted that the only miss that analysts recorded since calendar year 2000 was for the last fiscal year when earnings were slightly down.

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Cisco Systems, Inc. (CSCO)

Cisco Systems Inc has only paid a dividend since fiscal year 2011.  However, its dividend growth rate has been impressive.  With a current P/E ratio of 13 and a dividend yield of 3%, I believe Cisco represents an excellent value at these levels.

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It should be noted that Cisco has only commanded a historical normal P/E ratio of 14 since fiscal year 2007.  This is clearly below my fair value baseline P/E ratio of 15.  However, even if you only assume that Cisco’s stock price moves to a P/E ratio of 14 by fiscal year-end July 2018, and further assume that analysts estimates are correct, this research candidate offers the potential for double digit returns in excess of 12% per annum. 

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It was not a surprise to see that the analysts scorecard on Cisco was not perfect.  After all, this is a tech stock and therefore, prone to moderate cyclicality.  Nevertheless, the company’s low valuation and 3% dividend yield indicate that AA- rated Cisco is attractive at current levels.

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International Business Machine (IBM)

IBM, once considered one of the bluest of blue chips, has been recently maligned due to earnings weakness.  However, I believe that IBM’s extremely low valuation and high dividend yield warrant consideration. 

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When calculating the potential future return on IBM out to fiscal year-end 2017, I chose to utilize a conservative P/E ratio valuation only moving to 12.8.  Although analysts expect only moderate growth for the next couple of years, today’s current low valuation would indicate high double digit return potential.

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Considering that future growth expectations are rather low, coupled with a reasonably high scorecard, I have confidence that IBM represents an attractive long-term opportunity.  To be clear, I believe that much of the risk associated with investing in IBM is already reflected in its low valuation.

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The Procter & Gamble Company (PG)

Procter & Gamble is a blue-chip dividend growth stock that has historically commanded a premium valuation.  Recent softness in earnings’ performance has driven the stock down approximately 10% since the beginning of the year.  Although this blue chip offers little in the form of growth, its dividend yield of 3.5% is worthy of consideration.

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Utilizing the company’s historical normal P/E ratio of 17.8 as a target, Procter & Gamble offers the potential to generate annual returns in excess of 7% out to fiscal year-end June 2018.  However, it should be noted that more than half of that return is expected to come from dividends.

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The most comforting aspect of the analyst scorecard on Procter & Gamble is the 2-year forward forecast record.  Consequently, this gives me confidence that Procter & Gamble might deliver on analysts’ expectations over the next couple of years.

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Royal Bank of Canada (RY)

Royal Bank of Canada is considered one of the best Canadian banks.  I found this research candidate interesting because it is a dual-listed security.  The following earnings and price correlated FAST Graph looks at Royal Bank as it’s listed on the New York Stock Exchange.  Consequently, this is the graph that would be best utilized by US residents.  Note that all data is presented in US dollars (USD).  Low valuation and high current yield is the primary attraction.

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Once again, utilizing a discounted historical normal P/E ratio of only 12.3 would indicate the potential for double digit returns out to fiscal year-end October 2017 in excess of 12% per annum.  High dividend yield and low valuation is the attraction here.

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The analyst scorecard on Royal Bank of Canada has been exceptional.  Consequently, I have confidence that future earnings forecasts are reasonable. 

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For those investors domiciled in Canada, the Royal Bank presents a more consistent historical record of earnings and dividend growth.  The following earnings and price correlated graph illustrates Royal Bank on the Toronto Stock Exchange (TSX) and all data is presented in Canadian dollars (CAD). 

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Devoid of potential currency exchange headwinds, the Canadian version of Royal Bank is more consistent than what we saw on the New York Stock Exchange version.  Nevertheless, the return potential for both US and Canadian citizens are similar. 

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S&P Capital IQ only provides analyst scorecard data on one year forward estimates for the TSX listing.  Nevertheless, analysts have been accurate with their forecasts.

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Cummings Inc. (CMI)

Cummings Inc has a moderately cyclical record of earnings growth.  However, its record of dividend growth has been consistent and strong.  The company’s recent earnings and revenue beat seems inconsistent with its recent weak price action.  Consequently, its low P/E ratio and above-average dividend yield appear attractive.

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Leading analysts reporting on Cummins appear to be very upbeat about their earnings over the next couple of years.  Consequently, this A+ rated dividend growth stock with a low debt-to-capital ratio and a dividend yield over 3% appears quite attractive in today’s overvalued environment.

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However, due to the cyclical nature of this company’s operating history, the analyst scorecard has not been as accurate as we’ve seen with other companies.  Therefore, prospective investors should monitor future earnings reports closely.  On the other hand, current low valuation and dividend yield might mitigate some of that potential risk.

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Qualcomm Incorporated (QCOM)

Qualcomm’s current low valuation is somewhat justifiable based on its recent earnings reports.  Nevertheless, the company appears attractively-valued with a dividend yield above 3% and a consistent record of dividend increases since they initiated one in 2002.

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If we assume that Qualcomm trades at its historical normal P/E ratio of 18 by fiscal year-end September 2017, the future return potential is extraordinary.  A quick glance at the historical earnings and price correlated graph would indicate that this is not the first time that Qualcomm experienced a moderate earnings drop. 

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The 1 and 2 year forward analyst scorecard on Qualcomm does indicate some caution.  Nevertheless, low valuation and high dividend yield indicate this candidate as an attractive opportunity.

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Archer Daniels Midland Company (ADM)

The primary attraction motivating me to include Archer Daniels Midland was its fair valuation P/E ratio and prospects for a return to growth next fiscal year.  Additionally, in spite of a moderately cyclical record of earnings, this Dividend Champion has consistently increased its dividend for 40 consecutive years.

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In spite of leading analysts expecting a flattening of earnings in fiscal year 2017, Archer Daniels Midland still calculates out to a total annual rate of return in excess of 7%.  The real attraction to this dividend candidate is its long history of dividend increases.

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The analysts’ record of forecasting future earnings is positive, but not as consistent as we saw with other companies on the list.  Nevertheless, the real story with Archer Daniels Midland is reasonable valuation and a long record of increasing its dividend.

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AFLAC Incorporated (AFL)

Aflac is a financial that has suffered with low valuation since the Great Recession of 2008.  Additionally, earnings growth has been weak over the past several years.  Nevertheless, Aflac is a Dividend Champion that has consecutively increased its dividend for 32 straight years.

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Even when you assume that Aflac will continue to trade at a discounted P/E ratio to the market average, the company still offers the opportunity for average total returns.  However, even in spite of low future earnings growth expectations, if the company were to once again be valued at a market multiple P/E ratio of 15, the annualized total return would exceed 23% per annum.  Consequently, I consider this an attractive long-term opportunity for the patient dividend growth investor.

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A strong analyst scorecard contributes to my confidence in analysts’ forecasts on Aflac.  Consequently, I see a low downside potential with a possibility of significant long-term upside.

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Summary & Conclusions

In this part 1 of a 2-part series I presented the first 10 of 20 attractively-valued high-quality dividend growth stocks with an average aggregate current yield exceeding 3%.  In part 2, I will present 10 additional fairly valued dividend growth stocks, some of which offer higher dividend yields as I move down the quality chain.  The fairly valued research candidates I will present in part 2 will offer an average aggregate current dividend yield exceeding 4.3%. 

Assuming an equal investment in each of the 20 research candidates provides an average aggregate dividend yield of 3.66%.  Although each candidate was primarily suggested based on the merit of fair or attractive valuation, the 10 research candidates in this article was primarily focused on quality.  In part 2, the 10 candidates presented were focused primarily on either yield or total return.

Consequently, the primary objective behind both articles is that there are fairly valued common stock opportunities even in today’s moderately overvalued market.  Admittedly, it is getting very difficult to find attractive valuation at any quality level.  Nevertheless, I believe that the research candidates presented in this series are worthy of consideration for those retired investors primarily focused on income.  However, thanks to fair valuation, I believe this group of 20 dividend growth stocks also offers a reasonable opportunity for capital appreciation.  Given the current high valuation of the S&P 500, I believe this group of stocks also provides the opportunity for market-beating future total returns as well.