The basis of stock valuation is that a stock is valued based on the future expectation of cash that the owners of the common stock expect to receive. A business has two options as to what to do with that cash flow: reinvest it back in the business or pay it out as a dividend. As we've seen, those cash flow expectations can be widely distorted during boom and bust times.
IN PICTURES: 20 Tools For Building Up Your Portfolio
Dividends Can Be Counted
However, dividends are real and tangible. A company cannot hide a dividend. It's either paid or it's not. In today's world of virtually non-existent earnings growth, dividends can be extremely significant. And many dividend yields today provide extremely attractive returns not often considered for the most conservative investor. (For more, see Dividend Yield For The Downturn.)
A Healthy Yield Dose
The healthcare industry offers investors many attractive yields today. In addition, the relative underperformance of the industry over the past few years also gives investors the possibility of capital gain in the stock. Many smart money managers, like Bruce Berkowitz at Fairholme, have been jumping on the healthcare bandwagon, convinced that the end result of the Obama healthcare plan will a bigger pool of insured recipients.
Ely Lilly (NYSE:LLY) currently sports a 5.8% yield. The company pays about $2 billion in dividends, protected by over $7 billion in operating cash flows in 2008. For the past three years operating cash flows have covered the dividend payout by more than two times. In the meantime, annual interest payments of $228 million means that investors can be comforted by the security of the dividend. One of Fairholme's largest postions, Pfizer (NYSE:PFE), currently yeilds 4.3% and a P/E of 12. Listening in on a recent Fairholme conference call, I learned that Pfizer, through a series of acquisitions, has become the fourth largest generic drug comapny.
AT&T (NYSE:T) offers income-oriented investors a blue chip name with a dividend yield rarely found in a company of its size and stature. At 6.8%, the dividend is at a historically high level. I doubt shares in AT&T will deliver outsized capital gain, but the shares do trade near their 52-week lows. The P/E is 11.5, and if AT&T shares appreciate by 4% to 5% a year, the dividend yield gives you a stock that is delivering double digit annual returns. (And that's the hidden value of dividends. For more, see The Power Of Dividend Growth.)
A Rare Oil Play
Despite the recent rally in oil, shares in oil giant ConocoPhillips (NYSE:COP) have stayed back. Warren Buffett was buying Conoco when it was trading in the $80s, though he has admitted that it was a mistake to buy Conoco at those prices. Today, the shares are at $43 and the dividend is at 4.3%. Conoco is one of those companies that does offer investors both a strong yield and a very good chance of a strong appreciation in stock price over the next several years. Conoco has a wonderful refining segment that benefits from lower oil prices. But the long-term outlook for oil remains positive thanks to growth of the emerging economies. (For further reading, check out A Guide To Investing In The Oil Markets.)
When it comes to dividends, two things matter most: first, the underlying company should possess strong attributes to deliver solid operating performance, and second, the security of the dividend should always precede the rate of the dividend. A 5% yield doesn't mean much if underlying business is weak and shares continue to decline. Likewise, a high yield that's only good for a quarter or two is less desirable than a satisfactory yield that can be counted on for years. (For more, see The Importance Of Dividends and Build A Dividend Portfolio That Grows With You)
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!