ABB Ltd (NYSE: ABB) is currently paying investors an above-average dividend yield of 3.7% while the Industrials sector median stands 1.5%. Even though this makes ABB look attractive relative to its peers, it’s useful to understand the company’s future dividend potential. Will ABB’s bottom line be the main catalyst driving future growth or maybe its payout ratio? Understanding these components and how they impact value may change your mind on the company’s future prospects.
Is A Dividend Analysis Appropriate?
A Dividend Discount Model (DDM) is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments.
However, before walking through my dividend analysis for ABB, it’s first helpful to determine if this is actually an appropriate technique to be used when estimating its fair value. Many analysts are often biased towards one specific valuation approach which is typically a mistake that can negatively impact investment decisions and result in trading losses or missed opportunities. Every company has unique characteristics that may require you to adjust your analysis.
Understanding leverage trends is the first step when determining what valuation analyses are relevant for a given company. When a company’s leverage doesn’t fluctuate or is expected to remain stable over time, then an equity valuation model (e.g. equity DCF, DDM) will be the most appropriate valuation technique. The reason for this is because when leverage is stable, interest expense on debt can typically be projected with much more reliability.
How do we check if a company’s leverage has been fluctuating or is expected to do so? This isn’t always straightforward but checking recent debt ratio trends can be a good indicator. ABB’s debt to equity ratio has stayed relatively stable over last few years hitting a low of 48.5% in December 2017 and a high of 49.6% in December 2015. This suggests that an equity valuation model is a suitable technique when valuing the company’s shares. Now does it make sense to use a dividend discount model knowing that an equity valuation technique is an appropriate methodology?