In my first post on the magic dividend formula I discussed how to estimate forward returns using the formula. The formula only requires the estimation of one unknown variable which makes it very easy to use. Today I want to discuss a different form of the exact same formula and a couple of ways to use it in your investing.
The magic dividend formula can be re-written into a form that solves for the price of the stock. Here it is;
P = Annual Dividend / (Required rate of return – Dividend growth rate)
This the exact same formula as I presented in the first post just written differently. Remember that dividend yield is just the annual dividend divided by price. Thus by taking the first version of this formula you can then solve for price with some simple algebra and arrive at this equation. There are several ways to use this formula. I’ll show you my favorite way via an example.
My favorite way to use this version of the formula is to gauge what expectations the market is pricing into the stock. This is by no means a precise science, after all the future is uncertain, but by considering a range of outcomes you can see what the market is telling you about a particular stock. Lets consider two very different stocks; Intel and Altria. I use a range of future dividend growth rates, several different required rates of return, and the current dividend and then calculate the implied prices. Here is the resulting table:
Note; in the formula k must be greater than g to be solvable. That’s the reason for the two NAs in the table.
My basis for the forecast of future dividends is always the historical dividend growth rates. I use the 5 yr growth rates most of the time. And to be conservative my future estimates are usually less than the historical growth rates. So, for example, since initiating a dividend Intel has grown its dividend at a rate of 37%. But in the last 5 years it has grown its dividend at 12.5%. This is quite common of newer dividend payers. Its much easier to grow a dividend rapidly from a low base. That’s one reason to use a more recent 5 yr growth rate. As for required rates of return, I use 10%, 13.3%, and 15%. My personal target is 10% with a 25% margin of safety which equals 13%. I’m building in margin for error in several places.
What does this table tell us about these two stocks? Lets take Intel. The current market price is $21.68. Looking at the table above tells me the market is pricing in about a 10% future growth rate at a 13% required rate of return, or an 11%+ growth rate at a 15% required return (you can also solve for this directly using the formula – 11.68% is the answer- but there is no need for such precision). As for Altria, its current market price is $24, the market is pricing in a growth rate of about 7% at a 13% required return, or a slightly less than 9% growth rate at a 15% required return. For both of these stocks, the market is pricing in reasonable rates of growth based on their history. The market expectations look a bit lower for Altria than Intel so at current prices it seems to be a better investment.
Another consideration is risk. By most measures of risk; price volatility, maximum drawdown, earning stability, etc… Altria also seems to be the better value at this point. One way to account for this is to use a higher required rate of return for more volatile, cyclical stocks like Intel. For example, in my case, I would use a 13% required rate of return for Altria and a 15% required rate of return for Intel. That means in the case of Intel I would need to be very confident of a dividend growth rate near 12%, the 5 yr historical average. In a previous post on Intel, I mentioned that $19 seemed like a good entry point for Intel – that would imply an 11% growth rate at a 15% required rate of return. Whereas for Altria I would only need a growth rate of 7%, 30% below the 5 yr historical average, to justify buying at the current market price.
In conclusion, this version of the magic dividend formula, can tell you what the market expectations are for a particular stock or several stocks that you have under consideration. You can then use your own investment requirements to determine if the current market prices represent good value or to determine what prices would make good entry points for particular stocks. And like the first version of the magic dividend formula it is very easy to use.