Wednesday, August 2, 2023

The NPV MMA Differential

How to you determine if dividend stocks are trading in excess of their calculated fair value? Capital appreciation is not the primary reason for investing in dividend stocks. Dividend fundamentals are what drive my purchase decision, and if I could only look at one metric it would be the Net Present Value of the Money Market Differential (NPV MMA Diff.)

Why would you assume the equity risk and invest in a dividend stock if you could earn a better return in a less risky money market account? When I look for worthy dividend investments, one of my first tests is to determine if the investment will perform better than a MMA over time. I use the NPV MMA Diff. calculation to help make this determination.

The basis of the NPV MMA Diff. calculation is a hypothetical $1,000 investment in a dividend stock and a Money Market Account. The value calculated is the net present value (NPV) of the differences between the dividend earnings of the stock and the interest income from the MMA over 20 years. Other assumptions include: 1.) dividends grow at a consistent dividend growth rate, 2.) dividends are reinvested, 3.) share price appreciation is not considered, 4.) interest income is reinvested in the MMA. Once calculated, The NPV MMA Diff. is compared to a target amount.

The target is based on the number of consecutive years of dividend increases. The formula is: Target = Base - (Years x Increment) + Minimum where Base=3,000, Increment=100, Minimum=500. Thus 0 years yields a $3,500 target and 30 years yields a $500 target. The MMA rate is an estimate of the average rate earned over a 20 year period. This rate is periodically validated by looking at a 20 year Treasury rate. For more information on calculating the NPV MMA Diff, see the D4L-PreScreen spreadsheet.

Some might ask, 'why not just target yields that are higher than the MMA Rate?' That ignores the most powerful concept of Dividend Income Investing - Dividend Growth. Compound interest (interest on interest) is a powerful concept, but growing, compound dividends is the income investor's most powerful ally.

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