The Dividend Adjusted PEG Ratio Can Help You Find Undervalued Stocks
A Trick for Valuing Stocks with High Dividend Yields
When it comes to investing in dividend stocks, some tools, such as the PEG ratio, don't work well in the real world. To compensate, you need to use something known as the dividend adjusted PEG ratio. This is a modified version of the PEG ratio that takes into account dividend income, making it easier to compare mature companies with smaller companies that are growing quickly.
For those of you who need a quick refresher, we talked about the PEG ratio, including working through several examples demonstrating how to calculate it, in an article called Using the PEG Ratio to Find Hidden Stock Gems.
In simple terms, the PEG ratio is a financial tool that takes the price-to-earning ratio, or P/E ratio as it is more commonly known, and adjusts it for the growth in earnings per share.
Why bother to learn this formula? Remember that the price you pay is paramount to the returns you ultimately earn. A great company can be a terrible investment if you spend too much to acquire your stake. The purpose of the PEG ratio is to account for the common sense notion that you can sometimes pay a higher price for a business that is growing quickly, and still make a lot of money, than you can paying a lower price for a firm that has nowhere left to expand or is experiencing declining net earnings. The PEG ratio might help reveal that a young startup in Silicon Valley is a steal at 50x earnings, while an old steel mill is expensive at 8x earnings.
To calculate the PEG ratio, you use the following formula:
PEG Ratio = (Price ÷ Earnings Per Share) ÷ Annual Earnings Per Share Growth
In a purely rational world with reasonably stable interest rates and modest inflation, the PEG ratio of all stocks would be 1.00, meaning the P/E ratio would be equal to the growth rate of earnings per share. A stock that was growing profits at 10% would trade at 10x earnings.
A stock that was growing profits at 25% would trade at 25x earnings. Of course, this theoretical ideal is far from the norm as investor sentiment, oscillating between fear and greed, the opportunity cost of investing in bonds based on the current interest rate environment, and a host of other factors cause the PEG ratio of all stocks to fluctuate over time.
The PEG Ratio Doesn't Work for Stocks With Rich Dividends
Often, when a company is very large and profitable, it returns most of the earnings to its stockholders in the form of a cash dividend. This can result in a situation where the company appears to be growing slowly, but in addition to the earnings-per-share growth, stockholders are receiving large checks in the mail that they can spend, give to charity, or reinvest in additional shares of stock. When this is the case, the PEG ratio alone is not sufficient because it will appear that an otherwise attractive stock is significantly overvalued, which may not be true.
In these situations, the PEG ratio doesn't work well because stocks with high PEG ratios might still generate an attractive total return. In fact, the odds are good that when you analyze most high quality, blue chip stocks such Procter & Gamble, Colgate-Palmolive, Coca-Cola, or Tiffany & Company, to name a few real-world companies, you will need to use the dividend adjusted PEG ratio, instead.
How to Calculate the Dividend Adjusted PEG Ratio
Learning how to calculate the dividend adjusted PEG ratio is easy. Investing legend Peter Lynch proposed a modification to the formula several decades ago:
Dividend Adjusted PEG Ratio = (Price ÷ Earnings Per Share) ÷ (Annual Earnings Per Share Growth + Dividend Yield)
Let's look at The Coca-Cola Company. When this article was first written on September 29th, 2012, the stock traded for $38.85 per share and had earnings per share of $2.05. The dividend was $1.02 per share, resulting in a 2.6% dividend yield. The ValueLine Investment Survey estimated the growth in earnings per share over the upcoming 3-5 years to be 8%. You may have agreed or disagreed with that figure, but for illustration purposes, it was the one we used in our calculation as the point was to learn how to calculate the dividend adjusted PEG ratio, not examine any one specific firm.
If you were using the regular PEG ratio formula, you would have calculated Coke's PEG as:
Step 1: PEG Ratio = ($38.85 ÷ $2.05) ÷ 8
Step 2: PEG Ratio = 19 ÷ 8
Step 3: PEG Ratio = 2.375
Is Coca-Cola really that overvalued? Had you paid attention to the cash you will be getting as a stockholder in the soda giant, which has very real value, you would use the dividend adjusted PEG ratio formula:
Step 1: Dividend Adjusted PEG Ratio = ($38.85 ÷ $2.05) ÷ (8 + 2.6)
Step 2: Dividend Adjusted PEG Ratio = 19 ÷ 10.6
Step 3: Dividend Adjusted PEG Ratio = 1.793
In both cases, if the growth in earnings per share was accurately predicted, it would appear that Coke is not attractively valued. However, we can tell from the second set of numbers that the company, while certainly no steal, is much cheaper than the PEG ratio alone would have you believe.
A Look at How the Dividend Adjusted PEG Ratio Worked Out From Our Example
Subsequent experience confirmed this. As I update this article on February 22nd, 2016, Coca-Cola's stock price is $44.03 per share, its expected earnings are $2.00 per share, and its dividend is $1.40 per share. (Note: There are some temporary accounting issues, especially involving foreign currency translation rates, causing the reported earnings of Coke to appear significantly lower than they otherwise should be under an owner earnings calculation.)
In the roughly 3.5 years since it was first published, you'd have enjoyed a total return of $9.095 per share on your $38.85 investment, consisting of $5.18 in unrealized capital gains and $3.915 in per-share cash dividends, or 23.41% overall. This worked out to a compound annual growth rate of somewhere around 6.2%, which is not spectacular but was certainly fair for what you paid. This is especially true given the strength of the business. As an owner of Coke, you held equity in the largest beverage company on the planet. Much more than carbonated soda, it sells and distributes everything from orange juice and tea to milk, coffee, and energy drinks. It's so enormous, it supplies an estimated 3.5% of all daily ingested non-alcoholic beverages consumed by people in the world, including tap water. A single share bought in the IPO back in 1919 for $40, with dividends reinvested, is now worth north of $15,000,000. Had we gone into another Great Depression, the odds of the firm going bankrupt were much, much lower than the typical publicly traded stock. In fact, during the last depression, one banker in Florida turned his town into the per capita millionaire headquarters of the United States by helping people acquire Coke stock, many of the fortunes that were created still existing today.
One Major Pitfall of Calculating the Dividend Adjusted PEG Ratio Can Happen When One-Time Items, Currency Fluctuations, or Other Exceptional Circumstances Distort Earnings Quality
The first pitfall of using the dividend adjusted PEG ratio is treating it like scripture Mechanical metrics are no substitute for reasoned judgment. Knowing when the numbers are reflecting economic reality requires the ability to analyze and income statement and tear apart a balance sheet. Given that we've been discussing The Coca-Cola Company, it'd be easiest for me to continue expounding upon it rather than introducing a new firm at this point.
In my own family, we used the Coca-Cola dividend reinvestment program to teach my youngest sister about investing. The business is so good that, on average, we expect it to compound nicely over the next 30, 40, and 50+ years. Beyond that, despite appearing to have a very high dividend adjusted PEG ratio at the moment, I more than doubled my husband and my personal Coca-Cola stake today and fully intend to still own it when we die, passing it on to our future children and grandchildren as part of the family trust. Additionally, I have Coke shares stuffed in some of the UTMAs we established for our nieces and nephews. There is Coke stock in my parents' retirement accounts. I have Coke stock shoved in my brother's retirement accounts. I take it as a general life rule that, whenever the valuation is fair, it's typically a good idea to add to the ownership, tucking it away forever.
We've been well rewarded for doing that. Coca-Cola has paid a non-interrupted dividend since 1920. It has raised that dividend in February of every year since 1963 with the newest hike coming only a few days ago when the per share dividend rate was increased by 6%. Year after year, Coke continues to shower us with money.
Look closely, though, and the current stock price of $44.03, with current earnings of $1.67, a current dividend of $1.40, and analyst estimated growth over the next five years of 2.20% gives a deceptive indication of what an investor might expect. Stick into the formula and what do you find?
Dividend Adjusted PEG Ratio = (Price ÷ Earnings Per Share) ÷ (Annual Earnings Per Share Growth + Dividend Yield)
Dividend Adjusted PEG Ratio = ($44.03 ÷ $1.67) ÷ (2.2 + 3.19)
Dividend Adjusted PEG Ratio = 26.37 ÷ 5.39
Dividend Adjusted PEG Ratio = 4.89
Recall that a perfectly rational investor should want his or her stocks to have a PEG ratio or a dividend adjusted PEG ratio of 1.00 or less and should seriously give pause if the figure ever exceeds 2.00 for an extended period of time absent some sort of exceptional set of circumstances; e.g., if you had a huge Coca-Cola stake with a lot of deferred taxes built up within it due to having made the investment decades ago, it may still make sense to hold it, especially if you enjoy a comfortable passive income. Why, then, would I not only continue to hold what we own, but buy more?
Simple. The current earnings and growth rate do not accurately represent underlying economic reality over the long-term. As the rest of the world has struggled, the United States dollar has skyrocketed to all-time highs. Coke generates an enormous portion of its revenue and earnings from outside of its home country. The strong dollar has been so severe that some of the nations in which it does business experienced substantial sales growth but that sales growth appeared as a decline in revenue once translated back to the dollar. This condition is not permanent. When you start looking at long-term horizons exceeding ten years, they become somewhat inconsequential. What matters is that Coke is selling more water, tea, coffee, milk, juice, and soda in nearly every corner of Earth; that share repurchases and dividends keep returning freshly generated wealth to owners. For the most part, as time passes, the company gets bigger, more profitable, and more deeply entrenched in the societies in which it conducts its operations. Adjusting for these factors, what I consider to be the real dividend adjusted PEG ratio is lower than the calculated figure at which we just arrived.
Another Major Pitfall of the Dividend Adjusted PEG Ratio Is a Tendency To Be Overly Optimistic About Earnings Growth Projections
The problem inexperienced investors and experts alike tend to run into when using a financial measurement such as the dividend adjusted PEG ratio is the innate human tendency to be overly optimistic about the future growth rate of earnings per share. Wall Street analysts are notorious for doing this. (As a defense, to remind myself not to fall into the same trap, I keep analyst reports and tear sheets going back decades in my office and library covering firms that were doomed for catastrophic collapse, sometimes within months of the glowing reports being penned. I make a point to periodically read them, especially prior to committing money to a new investment.)
Another pitfall is not knowing when it's acceptable to ignore the metric on the edges of the portfolio. Going back to The Coca-Cola Company, as an illustration, there are times when you are building a truly permanent portfolio; a portfolio to hold for generations.