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.