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.