Investing is hard
Knowing when to buy is one of the most difficult things to do in investing. Retail investors often totally disregard this point, buying securities because of the name only. This is probably why retail investors have poor returns when buying individual stocks: They don’t have a plan.
This post will help you to have a plan when investing in dividend growth stocks and explain one of the primary and simple models that I use to get to a ballpark valuation of a dividend growth stock or REIT.
I’ll start out with a quick note on valuation versus investment decisions. The reason that I’m doing this post first versus doing a more fundamental analysis of financial ratios is that I look at valuation first to see if a REIT is worth exploring deeper. If the valuation is outrageous, then I know I can move on to other options that might be more reasonable. However, if it is within some margin of being in the right valuation (probably within 10-20% of current price), then there might be fundamental factors that I might want to check in on.
REITs are a great situation where a simple model is a good representation of reality. In finance there are several different ways to value income streams, whether they are from equities or bonds. However, some are more useful in some situations than others. It is extremely difficult to predict the future income stream of a high growth SaaS company or Venture Capital investment. On the other hand, bonds are typically relatively predictable with a relatively simple discounting process of future incomes and some estimate of probability of default. REITs are somewhere in between. The underlying real estate assets are stable and the recurring income is relatively forecastable since commercial leases typically have rent escalators.
The dividend growth model, also known as the Gordon Growth Model, is simple in concept and application. It effectively states that given an equity with an income stream, project its growth into perpetuity, and discount it by its cost of equity. Wikipedia, of all places, has the best easily-consumable explanation of its derivation.
P = Price
D1 = Projected Dividends in Year 1
r = Cost of Equity
g = Projected Growth
P = D1 / (r – g)
One of the classic dividend growing REITs that a lot of investors love is Realty Income. It has consistently grown its dividend over the past 20 years with predictability and stability. It is a great example of the type of REIT that fits the dividend growth model well.
Let’s start with Realty Income’s dividends. They have a current dividend rate of $0.22 paid monthly. Over the last year, the rate has grown from $0.2115, or 4%. A historical look at their dividends sees that they have consistently grown at around that rate for several years. This helps us derive both D and g.
For simplicity’s sake we will assume that Realty Income will grow their dividend over the next year by 4%.
g = 4%
D1 = D0 annualized * (1 + g)
D1 = $0.22 * (1 + 4%) = $0.228 per month * 12 ~= $2.75 / year
At this point we have two-thirds of our equation. The last part is r or the cost of equity. Cost of Equity is the risk premium that you would need to take on to invest in a company versus a “risk-free” investment like a treasury bond. This premium excludes inflation from affecting the valuation. There are several academic ways to to get cost of equity, but there are also freely available tools that provide this if you google around. My favorite so far is Finbox. When you start to dig deep into their tools they actually have pre-built models like the dividend growth and discounted cash flow with some of their own assumptions. I don’t particularly like their assumptions around growth, but I do like how they calculate cost of equity since it’s less dependent on assumptions and more dependent on the stock’s underlying volatility.
At the time of this writing, Realty Income’s cost of equity is 8.7% according to finbox. This seems appropriate based on the assumption that an individual stock investor would want to earn a significant premium on the cash that they invest over a CD or bond. This would target about an 11-12% nominal return using 3% as the long-term benchmark for risk-free rates.
So now we have our final piece of the equation: r = 8.7%
P = D1 / (r – g)
P = 2.75 / (8.7% – 4%)
P = $58.51
At the time of writing O is trading at $58.85, well-within the margin of error for a valuation. This provides a good deal of confirmation that other investors believe the dividend growth model is a good approximation of value. It doesn’t always work out this way. Some REITs are more growth oriented or have another factor that reduces risk and juices dividend growth rates or changes equity risk premium.
I would consider Realty Income to be fairly valued at the moment, and worthy of additional fundamental scrutiny as an investment. In fact, it made the short list of potential investments for me earlier in the year before choosing EPR Properties. It is a well run company that is consistent and conservative. As I add more low-risk REITs to my portfolio, Realty Income will likely be included. At the moment though, I have another strategy to invest in somewhat distressed, but still well-managed REITs. This strategy targets slightly higher yields and potential absolute returns.
I hope this was a good overview on how a simple model like the Dividend Discount / Gordon Growth Model can be a good first step when evaluating REITs as investments. I’ve automated much of this into a web application that I use as a screening first pass when I’m looking for potential investment candidates. This model can be used for dividend growers as well, but there is usually a bit more forecasting risk involved since they are operating companies so there is a little more nuance involved in valuation. I’d love to hear any thoughts on how else you evaluate your investments in the comments!
Finally, be sure to pick up my FREE dividend position tracking spreadsheet. I include a Dividend Growth Model calculator in the spreadsheet to help you value stocks on your own.
Also check out my book Too Much Money for a strategic and tactical approach to dividend investing for current income. These two tools together will help to jumpstart your investing journey!