Is That Dividend Stock Undervalued?

One of the rules of stock investing is that you want to buy a stock at a good price. It’s important to make sure that you are getting a good deal. If you pay too much for a dividend stock – or any stock – it could come back to haunt you, especially if the value doesn’t appreciate as you would expect. An undervalued stock, though, can make a great addition to your portfolio.

An undervalued stock is one that has a price that is considered low as compared to its intrinsic value. This means that a stock might considered “worth” $50 a share, but that, on the market, it is priced at $30 a share. The stock is undervalued, since, if you take into account the possibility of future cash flow, and the growth of the company, it should be priced higher.

Unfortunately, it can be difficult to determine whether or not a dividend stock is undervalued. Just having a low price isn’t enough to say that a stock is undervalued. There are plenty of low-priced stocks that “deserve” those prices. They might be declining in value due to any number of issues, none of them related to the fact that the business is a solid one with good future potential. Buying a low-priced stock just because it is cheap can be one way to see losses down the road. A poor stock choice will continue to lose value, now matter how “bargain” the price appears now.

How Can You Tell if a Stock is Undervalued?

As with most subjects related to investing, there is no sure-fire way to ensure that you are purchasing an undervalued stock vs. a cheap stock. However, there are some clues that, combined, can help you figure out if a stock is undervalued:

  • P/E ratio: The price to earnings ratio is a popular measure of stock value. The lower the number is, the better the valuation. So, a stock with a P/E ratio of 5 is better than one with a value of 10. However, you have to dig a little deeper. Why is the P/E ratio so favorable? If the P/E ratio comes as a result of a decline in profitability, or if it is realized through capital gains profits, the stock may not be undervalued after all.
  • Good credit rating: While ratings agencies do have their weaknesses, a credit rating can be an indication of the financial health of a company. A company with a good credit rating, and/or low debt levels, could be undervalued.
  • Stable earnings history: Many “boring” companies don’t always get the credit they deserve as solid investments. As a result, they might be priced lower than their value would suggest they should be. Look at the trailing three-year earnings, and whether they have risen, on average, over the last 10 years.
  • Dividend payouts: You can also look at dividend payouts. Have they been steady over time? If so, it could be an indication of a strong company that is undervalued.

There is no way to guarantee that you are getting the best possible value when you invest in any dividend stock. But you can do your homework and increase the likelihood that you will buy an undervalued stock.

Choosing Dividend Growth Stocks

One of the ways that you can prepare for the future, and build your wealth, is to invest in dividend stocks. Not only do dividend stocks provide you with the chance to enjoy capital appreciation, but you can also receive regular dividend income.

Dividend growth stocks can add even more to your portfolio. These are stocks that have the ability to grow in the future, and continue to grow their dividends. You can start with some of the dividend aristocrats, and see which are likely to continue to provide growth in dividends and in value.  Dividend growth stocks can offer you the chance to build wealth and income.

How to Pick Dividend Growth Stocks

As you decide which stocks to include in your portfolio, you should look at your options, as well as your goals. While you want your dividend stocks to reflect your future needs and desires, you also want to make sure that you are getting a good deal.

One thing you can do to calculate stock valuation is to use the dividend growth model. Before investing in a stock, it can help to have an idea of whether it is a good deal. Is it inexpensive for its expectations? Is it likely to grow enough in the future to justify its current valuation? Looking for an undervalued dividend stock can be a good move.

You can also look at some of the fundamentals of the company. Is the business model stable? Does the company manage the company in way that is likely to ensure that growth can be sustainable? Some of the best choices for a dividend growth portfolio are a bit boring: Mature companies with a history of paying dividends – and raising them. Sound balance sheets can also be good indicators that a dividend stock is a good choice.

Selling Your Dividend Growth Stock

When you buy a dividend growth stock, remember that you do so in an effort to hold on to something that will provide you with value now and in the future. That means that dumping it at the first sign of market trouble isn’t the best choice. The decision to sell a stock should not be taken lightly.

Before selling, consider your goals. Long-term, is the stock still likely to do well? If so, it might be worth it to hold on to the stock for a little bit longer, wait for it to recover. Plenty of great companies see their stock prices fall during a crash; that just means it’s a good time to get good deals. Instead of selling as a knee-jerk reaction to the markets, consider selling only if something changes fundamentally about the stock.

Should You Borrow to Invest in Dividend Stocks?

A number of dividend investors become somewhat impatient when building an income portfolio. And with fairly good reason. After all, building a solid income portfolio takes patience and time. In some cases, it might desirable to buy a large amount of stock in a dividend paying company because the price is low, or because you are hoping to kick start matters.

In such cases, some investors decide to borrow in order to invest. While this can be a good strategy – especially in an environment where interest rates are low – it’s important to be aware of the risks.

Advantages of Borrowing to Invest

Recently, The Dividend Guy wrote a post about using leverage to fund your investment purchases. It’s an interesting post about how you can borrow money to be able to make a move right now on solid stocks. You can boost your income portfolio, plus get good deals that are likely to appreciate in the future, providing you with bigger capital gains down the road.

Borrowing means that you don’t have to have the capital sitting in your bank account right now in order to purchase stocks. Plus, with interest rates so low right now, you can borrow at a low rate. Hopefully, your income from dividends, plus the appreciation of the stock, will result in returns that more than make up for the low interest you are paying on the loan. When you use leverage, in many cases you can boost your returns since you aren’t using your own money to make money.

Risks of Borrowing to Invest

Of course, there are risks associated with borrowing to invest. The biggest risk is that your decision will backfire, leading you to magnify your losses. If the stock crashes, you still owe the money, plus interest.

Even if the stock doesn’t crash, it might not gain as much as you expected. As a result, your gains can be reduced by the combination of inflation, taxes, and the interest you pay on the loan. So, even if you don’t lose big time, you could still find yourself without as much as you had imagined. There is a chance that you might have been better off using dollar cost averaging to slowly build a portfolio without paying interest on a loan.

Bottom Line

Leverage can help you magnify your gains – but it also magnifies losses. Before you decide to borrow to invest, consider the investments you want to make, and whether or not you are likely to see returns that will make up for the interest you pay on your loan. If you choose carefully, and get a low-rate loan, you should be able to maximize your investments. Make sure, though, that you will be able to handle the payments, and that you can absorb any losses that do come along.

Dividend Taxes: Qualified vs. Non-Qualified Dividends

For the last few years, there have been tax breaks for investors with long-term capital gains, as well as for qualified dividend investors. As part of a tax deal at the end of 2010, favorable tax rates on qualified dividends were extended through 2012, so the same tax rates apply to qualified dividend income as apply to long-term capital gains. Right now, that means that those in the 10% and 15% brackets pay no taxes on such income, and those in higher brackets pay 15%.  (Everything could change starting in 2013, depending on what Congress decides to do.)

This situation means that many people have been enjoying tax-free dividend income – as long as it’s qualified. You need to have an understanding of qualified dividends vs. unqualified dividends if you expect to fully take advantage of your tax status:

Qualified Dividends

Information on dividends, and how they are taxed, can be found in IRS Publication 550. “Qualified” status is awarded to dividends that are paid by a U.S. corporation, or a properly qualified foreign corporation. In most cases, the dividends you earn as a result of stock held in most U.S. C corporations are considered qualified dividends. Additionally, you must meet a specific holding period.

In order to be “qualified,” the IRS says that you must own the stock for more 60 days during the 121-day period beginning 60 days prior to the ex-dividend date. As long as you keep things relatively simple, this is fairly easy to figure out. Things start to get a little more difficult when you use option strategies. You might need a tax professional to help you sort things out in more complicated scenarios.

Non-Qualified Dividends

Even if your stock holdings meet the requirements above, there are some dividends that are never treated as “qualified.” You should be aware of these dividends, so that you don’t make the mistake of paying less in taxes than you owe. Here are the items that the IRS says will never be treated the same as “qualified” dividends:

  • Capital gains distributions.
  • Dividends paid from tax-exempt corporations or famer’s cooperatives.
  • Dividends received from deposits with credit unions, building and loan associations and financial institutions that are structured similarly.
  • Payments received in lieu of dividends, if you have reason to know that they are not “qualified” dividends.
  • Dividends paid on ESOPs maintained by corporations for their employees.
  • Dividends from stock shares that require you to make related payments for positions that are in substantially similar or related properties (such as in the case of a short sale).
  • Shown dividend payments in box 1b of Form 1099-DIV from a non-qualified foreign corporation.

If you have questions about the status of your dividend payments, it’s a good idea to double check with a tax professional or investment professional. Non-qualified dividends are taxed at your normal tax rate, so if you are in a marginal tax bracket above the 15% level, you will have to pay that tax rate.

Roundup: Happy Thanksgiving Edition

Hope you have a great Thanksgiving (those of you in the U.S. — we know Canadian Thanksgiving is past). Here are a few blog posts from the past week to give you something to do in between turkey and Black Friday:

  1. Implementing a Withdrawal Rate Strategy: Are you looking for a strategy to help you withdraw your money from your retirement account? Oblivious Investor looks at your options, and helps you figure out how to accomplish the best withdrawal strategy for you.
  2. Understanding the P/E Ratio as a Valuation: For those who are looking for more valuation tools, you can use P/E ratio. The Dividend Pig takes a look at what the P/E ratio is, and how you can use it as you evaluate stocks.
  3. When do you plan to be mortgage free?: The Passive Income Earner takes a look at the idea of becoming mortgage free. Do you have a goal to get rid of all of your debt? This might be a good post to check out.
  4. It’s All About the Numbers – Part 2: The Balance Sheet: Dividend Ninja offers a post on how to read a company’s balance sheet. If you want to make the best possible decision when it comes to building your dividend portfolio, the balance sheet is important.
  5. Uncommon Portfolio Diversification: Step outside the box when it comes to diversification. The Dividend Guy offers some great information diversification and asset allocation.
  6. Dividend reinvestment and rebalancing is easier and cheaper with index funds: Monevator takes a look at how you can use index funds to rebalance and reinvest — without paying such high fees. A great help for those looking to change things up a lot, or tweak a little.
  7. Ahead of the Herd with NioGold Mining: Beating The Index shares some ideas about NioGold Mining, and its potential. A information-packed post.

Selling When a Stock Cuts Its Dividend

When it comes to dividend stocks, the general rule is buy and hold. So, a number of people believe that they need to stick with a dividend stock, even after a dividend cut. And, while abandoning a stock at the first sign of a small dividend cut may not be quite your style, any cut should provide you with food for thought.

Reasons a Dividend Cut Matters

When a company cuts its dividend, it matters. It’s true that a dividend aristocrat that stops raising its dividend each year, and falls off the Dividend Aristocrats list, can be a concern. But a company that cuts its dividend – or eliminates it altogether – is something different. This can be an indication that things are going to change, and maybe not for the better. Here are some things a dividend cut can presage:

  1. Losing market share: In some cases, a company that has to cut its dividend does so in response to the way its market share is shrinking. When that happens, that might mean that the company is losing ground – and may not be able to provide the kind of growth that will result in sustainable dividends in the future.
  2. Cash problems: A company that cuts its dividend often doesn’t have the cash to continue to give some of its profits to shareholders. This can mean that revenues have fallen (due to market conditions or to some other problem), or that expenses have risen. It can also be a sign of mismanagement. In any case, cash problems can be an indication that problems are on the way. A dividend cut can be indicative of problems.

Before you get too hung up on dividend cuts, though, consider the situation. Following the global financial crisis, almost all financial institutions cut their dividends. They were all on shaky ground, and cash was a real problem. However, now many banks are starting to raise dividends again – although it might be years before dividends recover. In some cases, a dividend cut is only temporary, and dividends are likely to be raised again. However, if you are relying on dividends for stable income, a stock that regular cycles through cutting and raising dividends is usually not your most reliable choice.

On the other hand, though, it is important to consider that there are companies out there that are managed so well, and have enough market share, revenue, and profitability that they can keep raising dividends, even during times of economic upheaval when other dividend stocks are faltering. (This quality is what makes the dividend aristocrats so attractive to many.)

Getting rid of a dividend stock is a serious decision. A dividend cut might be a sign that the company is in trouble, and it might be time to unload. However, before you decide to sell, it’s a good idea to consider your options, and make sure that you can replace the stock with another dividend stock. One that might provide you with better performance and more reliable dividends.

Make Your Investment Dollars Work Harder For You

Income investors know about efficiency. They know that income comes from two sources: First, by making their money work as hard as it can and second, reduce commissions and taxes to their lowest possible level.

In the case of the latter, it’s a little more straightforward. Reduce your tax liability by holding on to our positions for at least one year and for long term investors, attempt to minimize your dividend payouts in your taxable accounts. For those with taxable brokerage accounts meant for long term growth, contributing the maximum to a traditional IRA and using that account for dividend names is worth considering.

Reducing expenses is easy compared to maximizing the work load of your money. Think of this illustration. A farmer who has 1,000 acres of land buys a high dollar tractor which will allow him to decrease the amount of workers he has to hire. That’s sounds like a great use of capital but what if he only used his new tractor on 500 of his 1,000 acres? Sounds a bit absurd, doesn’t it? It is, but investors do it with their money every day.

Here’s one example. If you have 100 shares of stock in a high volume, relatively low volatility company, you should be selling covered calls from time to time. There are plenty of articles explaining how covered calls work so we won’t dive too deeply in to the mechanics but if you have a stock that is currently towards the top of its range, consider selling a covered call against your 100 shares.

Let’s say that the stock is currently at $45 and that’s the high end of where it has traded. Why not sell a covered call with a strike price of $47? The worst case scenario is that by expiration the stock is above $47 and you are forced to sell the stock at $47. You made $200 plus the premium you collected when you sold the call. You could always buy the stock back or purchase another 100 shares if the stock goes significantly above the strike price.

Covered call options are a more complicated than simple stock buying but it pays to take the time to learn how they work. You won’t make extra money every month but even after paying short term capital gains taxes on the premium you collected, it’s still more money than what you had.

Another way to maximize gains, besides dividends, is to ask your broker if they have a program where they use your shares for lending to short sellers. Often, you will receive 20% to 50% of the lending fee and in most cases you’re not impacted in any way as long as you plan to hold the stock long term.

Bottom Line

Income investors shouldn’t use dividends as their sole source of revenue. There are other strategies that can be used to produce income with various degrees of risk. Of course it’s always advisable to have a paper account where you can practice these strategies before putting real money to work.

20 Potentially Undervalued Stocks With High Dividend Yields

Value investing is back.  Investors are flocking to anything with perceived value to avoid the market swings we are seeing every day.  There are many different methods and formulas you can use to identify undervalued dividend stocks.  The dividend growth model is one that we have mentioned before.  Discounted cash flow and comparing current dividend yield to average yields are also often used.

We didn’t use any of those models to identify these three stocks.  Instead we first found stocks trading at a price to book value ratio of less than 1.  We further filtered that list down by removing any stock with a P/E and PEG ratio above their specific industry average.  It’s important to compare P/E ratios to industry averages instead of index averages because not all industry trading at the same level.

After drilling down into value we then sorted stocks by dividend yield to only include those with a yield of 3% or more.  We ended up with over 20 stocks many of which are REITs.  Each of these stocks has a story and it’s important to do your homework to determine if these fundamentals are predicting a big upside or a possible problem at the company.

A good example would be two stocks you’ve probably heard of before – Whirlpool and Computer Science Corp.  Both had disappointing earnings results recently and have analysts concerned about future growth.  Other stocks such as Transocean have solid fundamentals, a high yield and the backing of many analysts making it one of the best dividend stocks on the list.

CompanySymbolPrice /
KT CorporationKT0.826.872.295.25
SK Telecom Co., Ltd.SKM0.926.50.884.95
Sims Metal Management Ltd.SMS0.948.540.53.41
Speedway Motor Sports, Inc.TRK0.6310.542.113.11
Hooker Furniture CorporationHOFT0.869.490.793.98
Brown Shoe Company, Inc.BWS0.957.390.483.17
American Greetings CorporationAM0.815.520.553.69
Seaspan CorporationSSW0.688.920.485.85
ArcelorMittal SAMT0.517.510.383.27
ITT CorpITT0.4320.28
Computer Sciences CorporationCSC0.885.790.673.02
Transocean LtdRIG0.7710.890.546.32
Whirlpool CorporationWHR0.988.340.563.41
Redwood Trust, Inc.RWT0.8811.12.479.3
Starwood Property Trust IncSTWD19.642.149.04
Apollo Commercial Real EstateARI0.858.671.1611.45
Chimera Investment CorporationCIM0.785.212.621.84
Colony Financial IncCLNY0.777.261.218.92
Ashford Hospitality Trust, IncAHT0.548.410.233.88
Hatteras Financial CorporationHTS0.996.893.8115.33

The 5 Best REITs with High Growth

REITs are a great way to get exposure to the real estate market while earning a high dividend yield.  REITs pay out 90% of their income to shareholders to avoid paying income taxes and therefore have very high dividend yields.  Because of this distribution norm these investments usually have a very high payout ratio.

On our REIT dividend list ranks these stocks based on historical performance.  Below is a list of real estate investment trusts that have a dividend yield over 4% and a dividend growth rate over 10%.

Digital Realty Trust – DLR

Digital realty trust buys, develops and manages technology related real estate properties. DLR owns 96 properties which are mostly in the US. 14 of those properties are in Europe. Most of their US property investment is focused in Dallas, Chicago and Boston.

DLR has a dividend yield of 4% and a 5 year dividend growth rate of 20%. They have increased their dividend for 5 consecutive years. DLR is tied for 9th position on our best dividend stock list. They have a 3 year net income growth rate of 36%.

Annaly Capital Management – NLY

Annaly is one of the most popular REITs because it has a high dividend yield and a history of increasing it’s dividend. NLY is a very diversified REIT. They invest in multiple forms of mortgage securities and also manage an number of different properties.

NLY has a dividend yield of 15.4% and a 5 year dividend growth rate over 40%. Their 3 year net income growth rate is 45%.

Two Harbors Investment Corp – TWO

Two Harbors investment trust was incorporated in 2009 so we don’t have a lot of history on them. They mostly invest in mortgage backed securities and related investments.

TWO had a dividend yield of 17.1%. They have just completed their second year of paying dividends and have a year over year increase of 16.25% in 2011.

Anworth Mortgage Asset Corp – ANH

Anworth invests in United States mortgage backed securities. The companies mortgage derivative security investments cannot exceed 10% of their portfolio.

Anworth has a dividend yield of 14.8% and a 5 year dividend growth rate of 107%.

Hatteras Financial Corporation – HTS

Hatteras Financial Corporation is managed by Atlantic Capital Advisors. They primarily invests in mortgage securities that are guaranteed or issued by government agencies.

HTS has a dividend yield of 15.3 and a 3 year dividend growth rate of 44%. They have increased their dividend for each of the last two years.

The Problem with Relying Too Much on Dividend Income

It’s true that an income portfolio can be a good way to provide yourself with a stream of passive income that can support you in the future. However, it is important to be careful. If you rely too much on dividend income, you might wind up in a difficult situation.

Main Issue with Dividends

The main issue with dividends is that they can be cut – or even eliminated – at any time. Companies are not obligated to keep paying dividends. They can get rid of them suddenly, or cut them during tough economic times when cash gets scarce. As a result, if you are relying too heavily on dividends, you could find yourself facing a significant decrease in your income if the investments in your portfolio suddenly cut their dividends.

At this juncture, especially if you are retired, or don’t have other sources of income, you might be forced to sell some of your stocks. In some cases, this can be a very inconvenient time because the stock price might have dropped as well. So, you will be forced to sell your holdings in order to get the cash you need, but you won’t perhaps, get as good a return as you would have liked.

Protecting Your Income from Dividend Cuts

As a result of this possibility, it is important to protect yourself from dividend cuts. Many people think that you have to be either a total return person, or a dividend person. The truth, though, is that you can be both. You can create an investing plan that allows you to create a portfolio that allows you to build up, on the one hand, investments that you know you will likely sell at some point, as well as create a dividend portfolio that provides an income stream.

You can also protect yourself to some degree by choosing your dividend stocks carefully. Some investors like the dividend aristocrats because the companies involved have raised dividends every year for at least 25 years in a row. With dividend aristocrats, there is a smaller chance that the dividend will be cut, much less disappear altogether. Of course, the possibility of a dividend cut or elimination is always there, but it is smaller.

Diversify Your Portfolio

It is also possible to diversify your dividend portfolio so that you have different types of stocks involved. That way, if cuts are more sector-based, you will still have other investments that will hold up, and possibly help make up for a dividend cut.

And, of course, you can prepare your finances by building up an emergency fund of some sort. That way, if you end up the victim of dividend cuts, you can draw on your emergency fund while you wait for your dividend stream to recover, or wait for the markets to improve so you can sell some of your investments later. You can also start a side business, or cultivate some other source of income to help provide you with a stream if dividends are cut.

Being prepared with different options can help you avoid the problems related to dividend cuts, and better prepare you for a successful financial future.