This is a guest post from Tom Vilord of Wall Street Value. 

If you have some cash to allocate into stocks, it is very difficult to find opportunities in this market. As I write this article (July 12, 2017), I received a CNBC text alert that the Dow just hit another record high.

With such high total market valuations, a lot of investors look for dividend paying stocks to find some yield. On the surface, this may seem like a very good idea. Most of the names in the Dividend Aristocrats portfolio are the large blue chip stable companies, that pay decent dividends, and historically have less volatility than the market as a whole.

Here are a few of the names in that portfolio that I really like: Johnson and Johnson (jnj), Kimberly Clark (KMB), 3M (MMM), Lowes (LOW), and Grainger (GWW). Every one of these companies have Financial Strength Ratings of A+ or A++ on Value Line. A++ is their highest rating. However, just because they are very financially stable companies with nice dividends, doesn’t mean you should just go ahead and invest your money in them because you can’t find opportunities elsewhere. DO NOT CHASE YIELD. I see a lot of investors buy into these types of stocks simply for the dividend and that could have huge consequences.

If you have read some of my previous articles, you will notice that I am a HUGE fan of Disney (DIS). They have great history of paying dividends, they have an A++ Financial Strength rating, their products and services are amazing, and could be a very good choice for the dividend investor. In 2015 I was looking into the company because I was hoping to move some proceeds from another investment into DIS. I did my analysis and one of the first things I looked wanted to find out was what did their normal historical valuation look like in terms of Price to Earnings.

I looked at 2 time periods: I looked at their 10 Year Average PE and their 5 Year Average PE. This gives me an idea of what a potential “Normal” valuation would look like based on their own history. Since they are a predictable company that has had the same products and services 5 and 10 years ago as they do now, I think this valuation method can be pretty accurate for this type of business. Their 10 Year Average PE is 16.3 and the 5 Year Average PE is slightly higher at 17.5. So, a normal valuation for DIS is somewhere in the range of 16 to 17.5. When the stock trades at a PE in that range, I would say it’s fairly valued based on their own history. I don’t want to buy a fairly valued stock. I want to buy it at a discount, so I would have to buy the stock when it is well below a PE of 16.

Source: Value Line

When I did this analysis in November of 2015, their PE was 24.9. At that time, the stock was around $120. That PE is about 50% higher than the 10 Year average PE. To put that into perspective, the last time DIS was that overvalued was in 2003 when the PE peaked at 28 (Source: Value Line Above). When anything gets that overvalued, it will come back down to normal valuations. That is exactly what happened in February 2016. DIS fell from approx. $120 down to $85 as you can see in the Think or Swim chart below.

The point is this: if you bought DIS in November of 2015 because it was a great company with a dividend, you would have seen your principal fall by 30%. DO NOT CHASE YIELD.

Another quick way to see if a dividend paying stock is at high, low, or fair range compared to history is to look at their historical dividend yield. For DIS, I looked at their 10 Year Average and 5 Year Average Dividend Yield and compare that to where the yield was in November 2015 when I did the analysis. The 5 Year Average Dividend Yield was 1.4% and the 10 Year Dividend Yield was 1.26%. This gives us a range where the stock is fairly valued. Any yield north of 1.4% represents a potential bargain and anything less than 1.26% is starting to look expensive. When the PE was 24.9 in 2015, the Dividend Yield was just 1.1%. This gave me confirmation that the price in November 2015 was a clear sign to stay away (or sell if you owned shares).

Investing in Blue Chip stocks for their dividend is great investment strategy as long as you buy wisely. Always invest in quality at a DISCOUNT.

There are two valuations that I really like to use on stable blue chip stocks that pay dividends. The first is Historical PE x Current EPS (or Estimated EPS if they have a high Earnings Predictability Score) and the other is Current Dividend Per Share/Historical Dividend Yield. We are looking for companies that are currently trading at a PE that is LOWER than their historical average PE with a dividend yield that is HIGHER than their historical average.

Let’s use these two calculations for each of the five companies I mentioned above that are in the Dividend Aristocrat’s Portfolio and see if any of these Blue Chippers are worth taking a deeper look:

Johnson and Johnson (JNJ), Kimberly Clark (KMB), 3 M (MMM), Lowes (LOW), and Grainger (GWW).

For each of these companies, I will be using Value Line to get their current and historical data. As I showed you in the DIS example, you can use a 10 Year and/or 5 Year Average to get the historical data. In the next five examples, I will use historical data for PE and Dividend Yield going back to 2010 (post-recession).

Johnson and Johnson has an Average Historical PE of 15.64 as seen in the chart below:

Source: Value Line

Their current PE is 22.29. Value Line gives them an Earnings Predictability Score of 100 which is their highest score. Since their earnings estimates are very predictable, I feel comfortable using their future estimates to get a target price. If we multiply the Historical Average PE of 15.64 x Estimated Earnings for 2017 which is $6.45 we get a price target of $100.87.

Now let’s look at the last line on this chart which shows Average Annual Dividend Yield. The Average Yield since 2010 is 3.14%. That’s much higher than their current yield of 2.4%. To get our second target price, we will divide their dividend per share of $3.15 by the Average Dividend Yield of 3.14%. 3.15/.0314 = $100.31.

So far we get a potential target price for JNJ of $100.87 and 100.31. Morningstar has their target price at $108. JNJ’s current price is $132.23. I don’t want to lose $30/share to get a dividend yield of 2.4%, so as great as JNJ is, this company is not for me right now.

How does Kimberly Clark look? Since 2010, their average PE is 19.38. I did not calculate the PE of 40 in 2015 as that is an obvious outlier year. Something out of the norm happened there. Using their Trailing 12 Month EPS, their current PE is 20.8 as seen below:

Source: Value Line

Value Line gives them an Earnings Predictability Score of 40. Since their predictability score flat out sucks, it makes no sense using their estimated earnings in this calculation. Their estimate of $6.30 by year end 2017 is a shot in the dark. I will base my target price based on Trailing 12 Month (TTM) EPS of $5.99. 19.38 x 5.99 = $116.

Using the data in the bottom line in the chart above, we get an average dividend yield of 3.47%. Their historical yield is a lot better than the current yield of 3.0%. Their dividends per share ending 2016 was $3.68. 3.68/.0347 = $106.05.

KMB looks like another company that I will pass on. My two target prices are $116 and $106.05. Morningstar has price target of $117. Currently, KMB is trading at $124.70. I don’t want to risk capital just to earn a current yield of 3%.

Next up is 3M, the maker of the sticky note and a million other products. Since 2010 their average PE is 17.2. Currently they are trading at a PE of 25.89 using TTM EPS.

Source: Value Line

Value Line gives them the best score for Earnings Predictability, which is 100. I will use their estimated EPS in this calculation. 17.2 x 8.90 = $153.08.

Their average dividend yield since 2010 is 2.50% and today it has a yield of just 2.18%. Remember, we want to buy a stock that has a current PE that is LOWER than its historical average and a dividend yield that is HIGHER than its historical average. They are currently paying a dividend in the amount of $4.44.

4.44/.025 = $177.60.

My two target prices are $153 and $177. Morningstar has a target price of $180. Today MMM is trading at $211.30. I will pass.

Each of the three companies we just looked at was given just a 2 Star rating out of a possible 5 Star on Morningstar. The star ratings are based purely on price targets using Morningstar’s proprietary methods. Companies with 1 and 2 stars are overvalued, a 3-star rating is fairly valued and a 4 and 5-star rating is any company they feel is undervalued.

The examples above clearly show why we can’t buy a great company based solely on the fact that it pays a dividend as so many investors do. We need to buy great companies that are at great prices. In this market they still exist, you just have to do more legwork to find them.

The following are two companies in the Dividend Aristocrat Portfolio that are both 4 Star rated on Morningstar. While neither of these are trading at a Margin of Safety that I would like, they still are trading at a discount, they are great financially sound companies, and they pay dividends.

First off is Lowe’s. They are the only company on the list that is not A++ on Morningstar, but it’s still not too shabby with a Financial Strength rating of A+. The average PE is 18.3. Currently they have a PE of 19.1 based on TTM EPS (and a current price of $76.22), but they have an Earnings Predictability Score of 100 on Value Line, so their PE based on Estimated 2017 Earnings is only 16.42. This is the first time in this article that we see a company with a current PE lower than historical averages.

Source: Value Line

Historical PE of 18.3 x Estimated EPS of $4.64 = $84.91.

They are paying a dividend of $1.40 per share (Morningstar). Their average dividend yield since 2010 is 1.78%. The current yield is higher at 1.84%. 1.4/.0178 = $78.65.

My two target prices are $84.91 and $78.65. Morningstar is more optimistic at $93. The current price is $76.22. Lowes is undervalued…not by much, but it’s still a better buy than the others that we have covered so far.

Lastly, let’s look at Grainger. Their average PE is 19.17. The recent huge drop brings their current PE down to 15.34. The stock was at $260 and it now below $170. Is this an opportunity or a value trap? Too soon to say. I will do more research, so I’ll get back to you on that one.

Source: Value Line

Sure Dividend note: W.W. Grainger ranked exceedingly well according to The 8 Rules of Dividend Investing in the most recent edition of the Sure Dividend Newsletter.

They lowered their Earnings Estimates from $11.58 in 2016 down to $11 in 2017, so let’s use their estimated earnings to get a potential target price. 19.17 x 11 = $210.87.

They pay a dividend of $4.83. The average yield is 1.77% and the current yield is 2.8%. 4.83/.0177 = $272 which I think is absurdly high, so we won’t use this one.

Morningstar has a price target of $202 and my other calculation gave us a price target of $210.87. The current price is $168.81. This MAY be an opportunity, but I need to do more research.

If you want some homework, take the calculations that I used here and run some numbers on Medtronic (MDT), Proctor and Gamble (PG), and Walmart (WMT) and let me know what you come up with. These were all 4 star rated companies on Morningstar and are also in the Dividend Aristocrat Portfolio.

If you are going to invest in dividend stocks, remember that valuations are still very important. Don’t be tempted by a dividend. Dividends are great. I love them. I invest in dividend stocks for myself, my clients, and my investment fund, but I will only buy those dividend stocks if I am able to buy the stock at a reasonable price.

Lastly, I wanted to show you a few valuations to give you an idea of why a particular stock may or may not be a good idea to invest in. This is not a complete analysis of any of the companies in this article. This is not a recommendation to buy or sell any of these companies. If any of these ideas interest you, please do your own due diligence and thoroughly research any stock that you may invest in.