After I’ve analyzed a dividend growth stock to determine if I believe it is a strong, stable and growing company worthy of my investment, I look to determine if I believe the current price of the stock makes it a good value. When making my initial investment and all subsequent investments in a company the current valuation is very important. An overvalued stock will leave you with low and unacceptable returns through the coming years. I look to invest in stocks that I believe are currently fairly valued or undervalued where I hope to give me the best chance of decent returns through the coming years.
Compare Current P/E with Historical P/E’s and Industry Averages
When doing my valuation, I don’t actually put a specific value. Rather I compare the current P/E ratio with historical P/E rates to determine if the current market price is at giving the company a historically high P/E or a average or below average P/E. I look for P/E’s that would be in line with historical average or below average P/E ratios. The P/E tells me how many dollars I am paying for each dollar of earnings a company has. I typically look for this number to be low. P/E ratios fluctuate across industries so a P/E may be high for one industry and low for another. Be sure to compare P/E’s with companies in the same industry and with the particular companies historical numbers.
Calculate and Estimate a Future Earnings Per Share (EPS)
I don’t base my buy decision purely on current P/E. I also will use the prior earnings growth of the company to project out a future price and an estimated return if that price is reached. When analyzing the company I calculated a 5 and 10 year earnings per share annual growth rate. Take this annual growth rate and use this online calculator to project out EPS 5 and 10 years at same growth rate. Enter the current EPS, the annual growth rate, and the number of years. This will then give us an expected EPS in 5 or 10 years. Remember this is just an estimate and most likely will be wrong due to differences in actual earnings per share growth compared to the historical rate we use.
Use the Future Estimated EPS to Estimate Price and Annual Return
When I have a future estimated EPS, I will use this number to calculate a future price. Take your future estimated EPS and multiply it by the historical low P/E ratio of the company. This will give a conservative estimate of the future price I might hope for from the stock. When I have my future estimated price, use this online calculator to figure out what my expected annual return will be by entering my current price, future estimated price and number of years. The output will be the estimated annual return of the stock.
Usually I will calculate out estimated annual returns of multiple stocks. I take this into consideration when deciding which company I believe will be the best to invest in at that particular time. Other things I take into consideration is current P/E compared to historical and industry averages, dividend yield, dividend growth rate and diversification of my portfolio.
Remember These Are Estimates
Remember that all these numbers I am projecting out are estimates. Chances are actual figures will turn out different then what I have estimated. However I believe by going through this exercise I will have a reasonable chance of not investing in companies that may be way overvalued leaving me with flat or negative future returns. When I am investing I am not necessarily looking for home runs. I am looking for stocks that will offer me reasonable returns through the years while paying me dividends that I can reinvest or live off of through my lifetime.
This may be a confusing post because it’s hard for me to explain my process. If you are confused feel free to contact me and I’ll try to explain it better. Also you can check in on Friday’s when I will put my entire process together to analyze and value individual companies.