One of the things that happened in response to interest rates becoming so low was that higher dividend stocks became even pricier. Even though prices seem to have come down recently, higher dividend stocks are, it seems, still a poor investment relative to other stocks.
Per S&P (Standard & Poor’s), the S&P 500 represents about 75% or 80% of total U.S. stock market capitalization. Below is a table showing the dividend rates, recent price performance, and price metrics for the 10 S&P 500 sectors. In viewing the table, keep in mind that interest rates in the U.S. hit a low at about the beginning of May and, then, rose significantly.
The three sectors with the highest dividend rates are, from the highest dividend rate sector downward, telecommunication services, utilities, and consumer staples. These sectors have declined the most in price recently. The price declines in telecommunication services and utilities have been relatively dramatic. Still, the telecommunication services sector has the highest P/E (price/earnings) ratio among all 10 sectors; the utilities sector has the fourth highest P/E ratio; and the consumer staples sector has the third highest P/E ratio. In terms of PEG (price/earnings to growth) ratios, the telecommunication services sector has the second highest; the utilities sector has the highest; and the consumer staples sector has the third highest.
There are two problems with the above metrics. (1) 5-year projected annual earnings growth percentages tend to be optimistic. (2) PEG ratio is a crude measure. Below, I will eliminate the optimism in the earnings growth projections; and I will apply a better metric than PEG ratio.
More Realistic Earnings Growth Projections
Using S&P data, I calculated the average as-reported profit margin for the S&P 500 to be 8.10% from Q4 2012 thru Q3 2010. By subtracting S&P’s (5/7/13) 2.17% indicated dividend rate for the S&P 500, we get a projected retained earnings percentage of 5.94% for the S&P 500.
Some people believe that there is a subpar return on retained (i.e., not distributed as dividends) earnings due to inefficient utilization by management. More specifically, they believe that, for example, 5.94% of retained earnings will, likely, lead to less than a 5.94% increase in earnings. I have studied this question in detail, and there is no clear answer. Basically, the answer you get is highly dependent on what years you include in the analysis period. Sometimes, the answer you get is that the return on retained earnings is above-par. As this is the case, for the purpose of this analysis, we will assume that 5.94% of retained earnings will lead to 5.94% of earnings increase. This is definitely O.K. to do, as the purpose here is simply to develop more realistic projected earnings growth percentages.
The 5-year projected annual earnings growth percentages in the table above reflect an S&P 500 earnings growth percentage of 10.67%. 5.94% is 56% of 10.67%. Multiplying the earnings growth percentage for each sector in the table above by 56% gives us the following more realistic earnings growth percentages.
A better metric than PEG ratio is estimating what theoretical P/E ratios will be 5 years from now. The P/Es are theoretical in that, in calculating, we assume dividends are reinvested without upping the outstanding shares count. I use this metric; but, if anyone else does, I am unaware of it. I call this metric FYFTh (Five Years Forward Theoretical) P/E. You can pronounce this as “fifth PE”. In calculating this metric, to keep things simpler, I assume a 0% tax rate for the dividends received, which gives the higher dividend items a slight advantage.
Notice that the FYFTh P/E for the telecommunications sector is the worst; the FYFTh P/E for the utilities sector is the second worst; and the FYFTh P/E for the consumer staples sector is the third worst. As these three sectors tend to be lower growth sectors and will probably be lower growth sectors five years from now, their FYFTh P/Es should be relatively low.
In previous articles, I showed that:
I. By far, too many people and entities have been promoting dividend stock investing in more recent years.
II. Almost no one is promoting an opposite investment philosophy.
III. The low interest rate environment has led to an even greater desire to invest in higher dividend stocks.
IV. Dividend stocks have performed more poorly than other stocks in the intermediate term.
V. Higher dividend companies are less financially sound than other companies.
VI. Dividend stock prices are not less volatile than non-dividend-stock prices on a longer-term basis.
VII. There can be a tax disadvantage in receiving higher dividends if you reinvest the dividends.
The data above indicates that the issue regarding higher dividend stocks being overpriced in relation to other stocks still exists. Higher dividend stocks are not an appropriate substitute for fixed-income investments. To the extent you should be overweight in stocks, do so; but, in doing so, do not focus on higher-dividend stocks or stock funds.