Determining a fair price for a dividend stock is a bit more complicated than it is when you are valuing income-producing real estate. For Real Estate the formula for an attractive investment should be 8 x the gross rent.
But businesses are more complex and dynamic than real estate properties. The market for rental properties is local, therefore easier to understand. Rental income is relatively stable. Rents can move up or down, but this happens gradually over a period of years.
There is not such an easy calculation for stocks. But there are ways to value stocks that are simple and give you a rough indication, if a stock is attractive, fair valued or expensive. The simplest is: the price-to-earnings (P/E) ratio.
The P/E-ratio compares the price of a company’s stock with that company’s profits/earnings. The logic behind this analysis is: if the company’s current ratio is higher than its historical average, it is expensive. If it’s lower than its historical average, it seems to be attractive.
Of course, for the performance of a stock it does make a difference when exactly you buy it. You should look to buy at or below its long-term value. But even the PE-ratio is a simple and a relative reliable indicator, if a stock looks attractive, dig deeper and use additional evaluation methods.
Like using the gross rent multiplier method for valuing rental real estate, using the P/E ratio for stocks can make it difficult or even impossible to buy more stock in undervalued companies for a long time. When the market is generally overpriced, P/E ratios are generally too high. There are times when you have to wait months or even years before the price of one of these attractive stocks becomes a buy. During these times, the cash portion of your stock account will get larger. Be patient and comfortable sitting on cash because your time will come!
Sven Franssen