Many people outside the investing community (and some within) often express their displeasure and confusion of the valuation of certain companies. “How can X company be worth Y dollars?” is the typical message expressed.
It is often difficult to surmise why certain companies carry such high valuations. I think many in the investing community at times shake their head when they see certain stocks having astronomical price increases. Stock prices are ultimately controlled by human judgment. As you and I know, our judgment can be flawed.
With flawed thinking and mis-priced stocks, what comfort can the inexperienced investor take with him/her? First, I would contend that in time the mis-pricing of assets corrects itself. Human judgment if flawed, but that does not mean our judgment is doomed to successive failure. Eventually, things do work themselves out and prices come back down to a more appropriate level (Historical: Tulip bubble. Recent: Dot-Com & Housing bubbles).
Secondly, a good strategy to avoid the chaos of speculative bubbles is to focus on stocks that pay a regular dividend and have demonstrated a commitment to growing the dividend distribution. According to Marc Lichtenfeld of The Oxford Club and Editor of The Activity Trader, if you are to look at historical market returns based on reinvested dividends into the market you would find:
- From 2000 to 2010, reinvested dividends were responsible for 87% of the S&P 500′s total return.
- From 1990 to 2010, reinvested dividends were responsible for 43% of the S&P 500′s total return.
- From 1871 to 2003, reinvested dividends were responsible for 97% of the stock market’s total returns.
The point to take away from this piece is that if you are looking for certainty in your stock market investments, you should be looking at companies (and funds) that are paying a dividend. Such companies are typically value oriented, as opposed to growth oriented. Growth stocks are usually the ones that are more prone to speculation.
In addition to looking at historical dividend payments, noticing their regularity, and distribution increases, I would look at the dividend payout ratio of a company. This is the annual dividend distribution per share divided by the annual earnings per share. The dividend payout ratio will give you a sense if the dividend yield you see associated with a stock is sustainable.
It’s worthwhile to note that the dividend payout ratio is a historical figure, which means you should also be aware of any foreseeable future events that may impact the company’s ability to pay its dividend. Don’t lose sight of the future while investigating the past.