Dividend investing is popular because investors like the idea of cash going into their accounts periodically. The dividend yield tells investors how much income they’d receive from a stock. If they buy $1,000 in a 5% yield stock, they’d receive $50 per year, assuming the stock maintains its dividend.
However, on top of the dividend yield, investors should also watch out for how much they pay for a stock. Depending on the riskiness of the stock, investors should demand a different margin of safety before buying.
How much margin of safety should you demand from a quality stock?
At $75 and change per share, Toronto-Dominion Bank trades at a multiple of roughly 13.1, which is within its fair valuation. Moreover, the company is estimated to grow its earnings per share by at least 9% per year on average for the next three to five years.
Furthermore, Toronto-Dominion Bank has maintained returns on equity (ROE) of at least 13% for seven consecutive years. In 2009, during the last financial crisis, its ROE was 9%, which was still very impressive.
The bank currently offers a 3.5% yield and pays out ~46% of its earnings. So, its dividend is very safe. The high single-digit earnings growth should lead to similar dividend growth as well.
If an investor waits for a big margin of safety in a quality company, they may be waiting for a long time. Toronto-Dominion Bank traded 40% below its intrinsic value in 2009, and it hasn’t traded at that low a valuation since.
Demand a bigger margin of safety for riskier stocks
For riskier dividend stocks, such as Alaris Royalty Corp. (TSX:AD), investors should demand a bigger margin of safety before buying. A risky dividend stock typically has a high yield. However, not all risky dividend stocks have high yields, and not all low-risk dividend stocks have low yields.
Alaris may offer a compelling yield of 9%. However, it’s riskier than the likes of Toronto-Dominion Bank. For example, Alaris has a much higher payout ratio of ~93%, which makes its dividend more susceptible to a cut when the company runs into trouble.
Yet, in the next 12 months, an investment in Alaris can deliver much higher returns than an investment in Toronto-Dominion Bank. On a forward basis, Alaris trades at a multiple of 10.4 at ~$18 per share.
Yet, the company has traded at much higher multiples before. So, it wouldn’t be far-fetched for the company to turn around and trade at a multiple of, say, 13, which would indicate a 12-month target price of ~$22.50, or 25% upside potential on top of the rich dividend.
Are you a conservative investor who would pay a fair price for Toronto-Dominion Bank today? Or will you take on more risk and invest in Alaris, which looks cheap, for a 9% yield and double-digit upside?
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Fool contributor Kay Ng owns shares of Alaris. Alaris is a recommendation of Dividend Investor Canada.