Today’s Wall Street Journal points out that despite weak EPS growth Procter & Gamble commands a higher PE ratio than Google because it has a juicy dividend. Investors reaching for yield are piling into high dividend stocks without paying much attention to their growth prospects or valuation. Current income is all that matters to them. How should investors think about this? Should they go along for the ride and buy the boring-but-now-hot high yield stocks like PEP, PG, JNJ, ATT, etc., or the neglected growth stock that don’t pay dividends? To set up an “apples to apples” comparison, I use the PE to Total Return Ratio (PETRR) calculated as follows:
PETRR = PE Ratio / (long-term growth rate + dividend yield).
It is not as simple as it looks, because assigning the correct long-term future growth rate requires a deep understanding of the company and the industry, which few people have. (Analysts tend to extrapolate the recent past, which is what made Apple shares look cheap at 680 and expensive at 480.) Let’s apply the PETRR to three stocks: PG, a slow-growing yield stock; GOOG, a growth stock paying no dividend; and AAPL, which is making an abrupt transition from “growth” to “value”:
Procter & Gamble: The PE on calendar year 2013 EPS is 18.8 and the dividend yield is 3.1%. I give it a growth rate of just 4% (which could be generous), because growth has been poor and probably won’t improve much. So the PETRR is 18.8/(4+3.1) or 2.65.
Google: The PE is 18.2x, it pays no dividend and I assign a growth rate of 12% (equal to its recent growth of 12%) because the company has a great core franchise and a track record of making smart acquisitions and finding new ways to make money on the Web. GOOG’s PETRR is 18.2/(12+0) or 1.52.
Apple: The PE is 9.5x, the yield is 2.9%, and I think it can grow EPS 6% annually via new products, international expansion, and share buy-backs. Obviously if new products are successful 6% growth could be way too low. But conservatism is appropriate given the risk of margin compression in a commoditizing device market. AAPL’s PETRR is 9.5/(6+2.9) or 1.07.
To put these metrics perspective, the PETRR for a diverse group of 40 stocks I follow is 1.3. In that context PG is ridiculously expensive, AAPL is cheap, and GOOG is somewhat expensive but arguably reasonably valued given its superb position in the Internet economy.
The Next Mania?
PG’s sky-high valuation suggests the “search for yield” may be turning into yet another mania created by the Fed. Savers earning nothing on their CD’s are migrating to funds and ETFs stuffed with high-yield paper ranging from REITs to MLPs to junk bonds to high-yield stocks—without paying much attention to valuation or growth prospects. What does this mean for stock selection? I certainly would not indiscriminately sell high-yielding food, beverage, drug, and utility stocks; some are still reasonably valued, and the search for yield could go on for a long time. But I would sell selected names with high PEs and mediocre fundamentals, such as PG.
Another implication: Investors should be searching for high growth companies that are being neglected because they don’t pay a dividend. In a world of 4% nominal GDP growth and 1.7% bond yields, a company that really can grow 15% per year deserves a PE multiple well above 20x, but not many stocks trade at that level.
The Search for Yield Is Supporting Valuation Levitation
The willingness of investors to pay up for yield is clearly bullish for the S&P 500 as a whole. The market tends to give investors what they want. If they want yield, they will get it – look at Apple’s 15% dividend hike last week. This year S&P 500 EPS will be about $109 and DPS $35, for a payout ratio of 32%–very low by historical standards. Companies have plenty of room to raise dividends substantially, despite a weak global economy.
If we assume that, over the next three years, earnings grow a paltry 5% per year but the payout ratio rises from 32% to 38%, then S&P 500 DPS would grow 11% annually to $48 in 2016. If the market’s dividend yield stayed at the current 2.2%, then at year-end 2016 the S&P 500 would be trading at 2400 (48/.022=2400). That is not a forecast, but it is a potent illustration of why it is a mistake to expect stock prices to decline just because profits are uninspiring. It is why “valuation levitation,” which I have been correctly forecasting for many months, is likely to continue.
Copyright Thomas Doerflinger 2013. All Rights Reserved.
