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If you’re relatively new to stock investing, you should start with stable companies that are undervalued and pay growing dividends. Now, it’s not easy to find a company with all three of these characteristics today. So, I’ll give some examples of what I mean by each.
What’s a stable company?
Stable companies tend to generate stable earnings and cash flow. It’s even better if their profitability increases over time. The big Canadian banks, including Toronto-Dominion Bank (TSX:TD)(NYSE:TD), are great examples.
Similar to the other big banks, Toronto-Dominion Bank typically increases its dividend every year. In the last recession, which was triggered by a financial crisis, the bank only experienced a 15% decline in its earnings in fiscal 2008. Its dividend was very well covered with a payout ratio of 42% for that year, but to be cautious, it froze its dividend that year.
Despite the earnings decline in fiscal 2008, Toronto-Dominion Bank still managed to grow its earnings per share on average by ~6.8% per year. With a roughly 3% dividend yield, long-term investors who paid a fair price for the stock are looking at a long-term rate of return of 9-10%, which is very good for a stable company.
What’s an undervalued stock?
A company is undervalued when it trades below its intrinsic value. The most common valuation metric is the price-to-earnings ratio (P/E). Toronto-Dominion Bank ’s long-term normal P/E is ~12.5, but at ~$73.70 per share, it trades at a P/E of ~13.2. So, the stock is not undervalued.
For a quality company such as Toronto-Dominion Bank, it hardly trades far away from that normal P/E. So, an investor should decide whether to pay a fair price or wait for a specific discount of, say, 10% below its normal P/E.
You can also look at the company’s estimated growth rate to determine if it’s a good value today. Analysts estimate that the bank will grow its earnings per share at a rate of 7.7-9.3% for the next few years. If so, the stock is roughly fully valued.
The magic of dividends
Companies that increase their profitability over time and have a culture of growing their dividends every year are some of the best investments you can make. Higher profitability leads to higher dividends and price appreciation.
While you own the shares of dividend companies, every time these companies declare a dividend, you’re entitled to receive the dividend. If you hold a quality, stable, dividend company long enough, you can get your entire investment back in dividends and more! The faster it grows its dividend (in a healthy way, of course), the quicker you can get your investment back.
New investors should look for stable companies that are undervalued and pay growing dividends. Toronto-Dominion Bank is a quality company that tends to grow its dividends.
Although the stock is fully valued, there are worse investments investors can make in today’s market. If you’re looking for a bigger margin of safety, consider scaling in the stock when it experiences meaningful dips of 5-10%.
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Fool contributor Kay Ng has no position in any of the stocks mentioned.