Famed investor and Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) CEO Warren Buffett is known for preferring value stocks and dividend stocks. He has seen success with both by investing in undervalued companies and by buying dividend-paying stocks that help fill his coffers, funding acquisitions and further stock purchases.

There is a clear overlap between the value stock and dividend stock categories, but do value stocks make the best dividend stocks? It's a common question among investors. In the article below, I'll first clarify how I define value stocks and dividend stocks, then examine the connections between the two categories, and look at both sides of the argument. Finally, I'll share my thoughts about whether or not value stocks actually do make the best dividend stocks.

A magnifying glass rests on top of several $100 bills.

Image source: Getty Images.

What is a value stock?

Value, like beauty, is often in the eye of the beholder, and in investing, value can be subjective. Generally value stocks can be described as companies that are currently valued below their peers despite having a solid core business and financial fundamentals, determined through certain valuation metrics.

Value may mean something different from one investor to another. Some investors, particularly growth investors, put a lot of emphasis on the future potential of a stock which is often debatable and difficult to quantify. The market is essentially a broad discussion about the value of companies, and everyday stocks move according to the balance in that argument. Amazon, for instance, has often been seen as an overvalued stock but some investors have been happy to pay up for what they saw as the growth potential of the company, and they have been rewarded. 

Still, there are some general guidelines for what can be considered value stocks. First, they're seen as the opposite of growth stocks, which tend to have high price-earnings ratios, low profits, and fast growth. Investors are generally willing to pay a higher multiple for growth stocks because they are viewed as having the potential to generate huge returns. 

Value stocks, on the other hand, tend to trade at lower P/E levels because they are growing more slowly, but are seen as undervalued by value investors. Value stocks are often older, mature companies that consistently generate strong cash flow, but have only modest growth potential.

Value investors also prefer to pick stocks based on fundamental metrics. For example, discounted cash flow helps value investors find stocks with intrinsic values greater than their market values, making them value stocks. That sort of valuation method gives investors a hard number to compare with a company's market capitalization -- this is the sum of all of a company's shares on the market, essentially the total value of the company according to the market.

Other investors look at price/book value, which shows the ratio of the company's stock price to its net assets on the balance sheet. For example, some investors see oil pipeline company Kinder Morgan as a value play since its price/book ratio is just 1.12, significantly less than its peers. As long as the balance sheet accurately reflects the value of the assets, that means investors can assess the value of a company's net assets and determine if the market is pricing the company at, or lower than, that value. If the P/B fell below 1, that would reflect an arbitrage opportunity for investors, because investors are paying less for the company than the total sum of its assets. 

What is a dividend stock?

A dividend stock is, quite simply, a stock that pays investors a dividend, or a share of the profits. In the U.S., dividend stocks tend to pay out to investors once every quarter, and dividend-paying companies often aim to increase their dividend every year as a reward to investors.  Companies that have raised their dividends for 25 years in a row are known as Dividend Aristocrats, an exclusive club that only a few dozen companies have gained entry to. Dividend Aristocrats are often considered among the best dividend stocks as they have demonstrated their ability to consistently reward long-term investors.

In addition to giving shareholders regular income streams, when a company pays a dividend -- and regularly raises it -- that should indicate that a company has a stable, reliable cash flow, and that it can be counted on to continue paying dividends. However, investors should also look at metrics like the payout ratio, which shows the percentage of earnings that go to fund dividend payments, as well as earnings growth, to see if a dividend will keep growing. 

The relationship between value and dividend stocks

Value and dividend stocks are close cousins in the investing world and often overlap as most value stocks are also dividend payers. That's because value stocks are often mature companies with stable cash flows and can, therefore, offer decent dividend yields.

Value investors like Warren Buffett will target dividend stocks as the income stream helps him fund future stock purchases and acquisitions. Dividend-paying value stocks also tend to appeal to retirees who are more likely to be looking for income rather than building a nest egg for retirement or college fund as younger investors are more likely to be doing. 

Unlike value stocks, growth stocks rarely pay dividends as the companies in this category often lack the cash flow necessary to do so. And if they have the funds, they would generally rather spend them on growth drivers like new stores or research and development. Since growth stocks tend to trade at higher P/E multiples, their dividend yields would also tend to be lower than those of value stocks and wouldn't attract traditional income investors, which means it's often not worth it for the company to pay a dividend.

Therefore, most dividend stocks tend to be found at the value end of the spectrum, rather than the growth end. Since value stocks aren't as likely to grow as much as growth stocks, a dividend for value stocks helps incentivize investors.

The importance of the payout ratio

The relationship between the P/E ratio and the dividend yield is important to understand here. The lower a company's valuation is, the more valuable the dividend becomes as the dividend yield increases. For instance, with a P/E ratio of about 12, Kohl's (NYSE: KSS) could be considered a value stock, and its dividend yields a respectable 3.9%. Its payout ratio -- the percentage of earnings that go to its dividend or dividend per share divided by earnings per share -- is also modest at 48%. Eighty percent is considered the maximum that dividend stocks should aim for in order to leave adequate cash flow for other needs.

The dividend yield and P/E ratio are functions of one another as a higher P/E ratio, meaning a higher price for the stock, will cause the dividend yield to come down. In order for it to go back up, either the stock price has to fall or the company has to increase its dividend payment, meaning the payout ratio would go up.

Here are the key formulas investors should understand.

  1. Payout ratio = Dividend per share/Earnings per share
  2. Dividend Yield = Dividend per share/Price per share
  3. P/E Ratio = Price per share/Earnings per share

The chart below shows different examples of how the numbers influence each other for a hypothetical stock.

Earnings Per Share Price   P/E Ratio Annual Dividend Payout Dividend Yield
$5 $50 10 $2 4%
$5 $80 16 $2 2.5%
$5 $40 8 $2 5%
$5 $80 16 $3 3.75%
$6 $60 10 $3 5%

Chart by author. 

As the chart suggests, low P/E stocks have an advantage over higher P/E stocks as dividend payers since -- all other things being equal -- a lower P/E will translate into a higher dividend yield.

Why value stocks aren't always great dividend stocks

 A low P/E alone is always a good thing as it doesn't necessarily signal a healthy dividend stock. Often, when stocks are trading at low P/E ratios, it's because most investors see their prospects as dim. Such stocks are often called "value traps" -- they appear to be value stocks, but their bargain-bin prices may just be luring investors into a bad investment.

Kohl's peer Macy's could be one such value trap. The stock yields 5.2% today and trades at a P/E of just 5.7. While those figures might seem to make it a great value/dividend stock to buy, it appears less appealing once you look at them in the context of the company's underlying business. It turns out that Macy's shares have fallen by 58% during the last three years, and comparable sales have dropped for 12 straight quarters until the company returned to growth for at least one quarter over the holiday season. Like many of its rivals in the department store space, it has also been closing locations, and investors remain skeptical about its future.

As the chart below shows, the companies dividend yield has grown with the falling stock price, even though the company hasn't raised its payout in two years.

M Chart

M data by YCharts

So, while Macy's looks like both a value and a dividend stock, that's a function more of its falling share price rather than its long-term health. Actual value stocks can also be good dividend stocks, but it's important that investors distinguish between healthy dividend payers and yield traps. 

History's best dividend stocks

A look at some Dividend Aristocrats, which are generally recognized as among the best dividend stocks to own, may help shed light on whether value stocks make the best dividend stocks. 

Altria (NYSE: MO), the tobacco giant behind Marlboro, has increased its dividends for more than 50 years, including the years before its split from Philip Morris International, and has been one of the best performers on the market in that time.

According to Wharton professor Jeremy Siegel, the stock, including dividends, returned more than 20% on an annualized basis between 1967-2017, and its dividend payouts were a big factor in those superior returns.   Today, Altria offers a dividend yield of 4.4%, but at times in the past, it has been much higher than that. Historically, Altria may have been undervalued due to the perception that declining cigarette smoking rates would weigh on the company's profits. However, the Marlboro-maker has overcome that challenge in part with price increases.

Other Dividend Aristocrats like Coca-Cola (NYSE: KO) or Procter & Gamble (NYSE: PG) have become slow-growth companies, but aren't necessarily cheap. Investors often pay a premium for companies with strong brands and long histories of success, paying up for the security of a reliable investment and dividend stream. Both stocks have significantly underperformed the S&P 500 over virtually every time frame you could pick in the last decade. In other words, a long history as a dividend raiser isn't a guarantee of outperformance, nor do the most consistent dividend stocks trade at value prices.

What's the answer?

Value stocks with stable businesses and high dividend yields can sometimes make great dividend stocks, and it's important for investors -- especially those focused on wealth preservation and income -- to not overspend on high-priced stocks.  

Picking companies with growing profits is also important, both because they support growing dividend payouts and its a good sign of a strong company. For long-term investors, dividend growth is just as important to consider as yield, as companies that consistently raise their dividends will give investors the greatest returns over the long run. Companies like Starbucks (NASDAQ: SBUX) exemplify this -- the coffee chain has raised its payout by 20% or more every year since it initiated its dividend in 2010. Stocks like Nike (NYSE: NKE) and Costco may have modest yields, but those companies have also raised their dividends by double-digit percentages nearly every year.

Given the evidence, the best answer to the question posed in the headline then seems to be yes -- value stocks can make great dividend stocks, but only when the companies behind them are also positioned to deliver dividend growth. It's important for investors to realize there are multiple factors at play in finding great dividend stocks.