Waste Management has been on a tear for investors over the past six months, outpacing the S&P 500's growth 17% to 6%, all while paying out hefty and increasing dividends. However, with the company recently reaching a new five-year high of $39.46, close to the company's all-time high, you'd be excused to start worrying whether the company is looking overvalued. After all, over the past six months Waste Management's price to earnings valuation has crept up to surpass that of the S&P 500 as a whole. Is it time to sell?
Unfortunately, there's no single answer for all investors. To understand whether investors should be buying, selling, or holding, let's look at the different reasons to invest in Waste Management in the first place. For Waste Management, the most compelling arguments have come from value investors and income investors.
Value investors could look at Waste Management's resilient business model, the necessity of its service, and conclude that the company was trading for less than it was ultimately worth. With such a rebound in the stock price recently, these types of investors may, indeed, look to cash out. For such a staid business as garbage collection, a trailing price to earnings ratio of 22 isn't just significantly higher than the S&P 500 average, it's also higher than Waste Management's historical ratio. Relative to its current earnings power, it's much more difficult to say today that Waste Management is undervalued, and those looking for quick value play turnarounds may wish to look elsewhere.
However, there are still solid reasons for holding the stock for more patient investors. The company is in the midst of a restructuring effort that, so far, has been quite successful at both cutting costs and bringing senior management closer to ground operations. The waste market in general could also be poised to turn a corner, as the North American economy gradually improves. A resurgent housing market, in particular, could push volumes and yield ever higher. Of course, these developments will take a while to play out, but that's where the best reason to hold Waste Management comes in: the fat dividend pays investors handsomely just to wait.
The curiously confusing case of dividend yields
Of course, as the price of Waste Management stock has increased, it's dividend yield has also decreased, from around 4.5% to 3.8% today. Or so it seems. When looking at any dividend investment, it's worth pointing out a common mistake that casual or first-time investors can be forgiven for making (advanced investors, feel free to skip ahead). When an investor looks up a stock quote for his investment and sees that yield has fallen, it's easy to be a little disappointed that the income stream has diminished. In reality, the projected yield that is so often displayed with a stock quote is only relevant to brand-new investors. The rest of us need to calculate our actual yields ourselves.
Websites that quote stock information calculate "yield" by adding up all dividends expected to be paid during a year, and dividing that amount by the current stock price, but if you bought shares at a different price than the current one, your actual yield on invested capital is different. In Waste Management's case, even though the current yield has shrunk because of a growing stock price, dividend payments actually have increased. That means if you bought shares at a lower price, your real yield is actually higher than it was, not lower. For example, if you bought shares in November for around $31 each, at that time Waste Management's quarterly $0.355 dividend payment (or $1.42 annually) would have worked out to about a 4.5% yield. Since then, Waste Management has upped its dividend by about 3% to $0.365 per quarter ($1.46 annually), but the stock price has jumped 25% to around $39. That's a current dividend yield of "only" 3.8%, but only on today's stock price of $39. If you actually bought shares for $31, your yield is the projected dividend divided by your purchase price, not by the current price. That means your real yield on invested capital has actually shot up to 4.7%! The capital appreciation is just a bonus.
The steadiest income stream money can buy
All this is to say that if you've invested in Waste Management for stable income, the investment thesis just keeps getting better. True, the dividend payout ratio spiked in 2012, from 67% of earnings to 81%, but long-term investors have nothing to worry about. Revenue actually grew in 2012, the dip in earnings was due to acquisitions and short-term costs associated with the ongoing, and necessary, restructuring program. Long-term investors should cheer management's willingness to forsake short-term profits in order to pursue a healthier cost structure and a stronger company in the future. Nothing about the necessity of Waste Management's services, its industry leadership, or its commitment to innovation has changed. Investors seeking safe, stable, and growing income should still look to Waste Management.
Motley Fool contributor Daniel Ferry owns shares of Waste Management. The Motley Fool recommends Waste Management. The Motley Fool owns shares of Waste Management. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.