Canadian Dividend Investors
1
When to Buy
Sometimes his (Mr. Market's) idea of value appears plausible and justifed
by business developments and prospects as you know them.
Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him,
and the value he proposes seems to you a little short of silly.
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Benjamin Graham
Benjamin Graham taught his students to distinguish between the financial value (the fair share value) of the common shares, which is grounded in the earnings of the underlying business, and the market price of the shares, which can be significantly different from the fair share value depending on whether investors are feeling positive or negative about a company’s financial prospects.
Professor Graham explained that a useful way of understanding the behaviour of market prices was by imagining the stock market as being an eccentric gentleman he called Mr. Market. Each day, Mr. Market offers to buy or sell the shares of the companies listed on the exchange at various prices, and each day you are free to accept or reject his offer.
Usually, the prices he quotes are reasonably close to the fair share values, but occasionally, his prices are considerably higher or lower than the fair share values of some companies. As an investor, you should take advantage of Mr. Market and buy the common shares of one of your favourite companies whenever the price he offers is much lower than the fair share value.
You can maximize your dividend income by buying the common shares of financially stable companies when the market price of the shares falls well below the fair share value. The degree by which Mr. Market is undervaluing the shares, with respect to the fair share value, can be calculated using the following equation:
.......................................... (1)
Based on this equation, when the market price of a company is equal to the fair share value, the degree of undervaluation of the shares would be 0%. If, as in this example, the market price of Sun Life were to fall to its lowest probable price ($60), the degree of undervaluation would be minus 100%, while if the market price rises to the highest probable price ($90), then the degree of overvaluation would be plus 100%.
The concept of undervaluation is illustrated graphically for Sun Life in Figure 1, in which the highest probable market price, the lowest probable market price, and the fair share value are shown, along with the current market price. which in this example is lower than the fair share value. In this example, the market has undervalued the shares of Sun Life by about minus 47% ($68 - $75) / ($75 - 60).
Figure 1: A graphical representation of the degree of undervaluation of the market price for Sun Life Financial.
I suggest that you determine the highest and lowest probable market prices and the fair share values of all the companies on your watchlist (or in your portfolio) and put them in a spreadsheet, such as MS Excel, as illustrated in Figure 2. Every few weeks, you can insert the most recent market prices into your spreadsheet, so that it will automatically calculate the degree of over or undervaluation for each company in your watchlist.
Figure 2: Example illustrating the calculation of the degree of over or undervaluation of the companies in my portfolio based on the market price.
As shown in Figure 2, on this particular trading day, Mr. Market appeared to be overvaluing the shares of all the companies in my portfolio, except for BCE and Telus, which were undervalued with respect to their fair share values by 70% and 9%, respectively. Before you decide to purchase any undervalued businesses, you should determine the reason the share price fell and assess whether the event that caused the price to fall will have a short or long-term effect on the company’s financial performance and its ability to continue paying a growing dividend.
It is important to understand that once you have purchased the shares, the annual cash dividend you receive will never change unless management decides to increase or decrease the dividend. For example, if the market price falls after you buy the shares, the dividend yield (based on the market price) will rise, from 5.0% to say 5.5%, but the cash dividend you receive will remain the same as before the market price fell.
Keep in mind that you are buying one of your favourite companies, such as Sun Life Financial, not because you expect the market price to rise in the next few months, but because you expect the company to pay you a significant and growing dividend income for the next several decades. Once you own all the shares you want of each of your favourite companies, you can ignore future changes in their market prices because they have no effect on your dividend income. You can (and should) focus all your attention on the businesses you hold and the safety of their growing dividends.
1. Graham, B., 1973. The Intelligent Investor, The Definitive Book on Value Investing, 4th Ed., Updated in 2003 with new commentary by Jason Zweig. HarperCollins Publishers, 10 East 53rd Street, New York, NY p. 205