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By Josh Peters, CFA | 06-25-2014 01:00 PM

Don't Overpay for Quality Dividend Stocks

P/Es could still rise further, but dividend investors should consider putting a ceiling on their purchase prices so they can maintain desired yields without paying too much.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. DividendInvestor editor Josh Peters thinks that the market might be at a pivot point, and he's here to talk about why.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start by looking at where the market is from a valuation standpoint right now. I know it's a topic we've touched on a few times in the past. Where are stocks? How do you view the overall valuation level?

Peters: One of the great things for stock-pickers is that you have the opportunity to go and pick individual stocks; you don't just have to accept the market average. However, what we've seen here this year is a lot of unanimity, really over the last couple of years. Everything tends to rise and fall in tandem, and valuation multiples tend to be pretty similar across even very different sectors of the market.

What I find here recently is that the bulk of the total return from the stock market over the last couple of years is explained by a rising P/E ratio on an operating basis, excluding nonrecurring gains and losses for S&P reports, that has come up from about 13 times earnings to 17 times, a little over 17 times here recently. That's right smack dab in the middle of its 30-year range.

So, if stocks were cheap a couple of years ago, and that set us up for us some additional gains, now we've got it. When I think in terms of a pivot point, my concern is that if stocks continue to go up significantly faster than earnings from here, which is a definite possibility, now longer-term investors are looking at the P/E being a headwind, that valuation multiples will come down in the longer run. At a fixed P/E, you earn a return that's equal to your dividend yield plus the earnings-growth rate for the companies you own or the market overall.

If the P/E is too high and that number comes down, you don't earn as much as the companies actually are providing in the form of return components. So this is making me a little nervous. It's not overvalued territory yet, at least on these shorter-run valuation metrics. Certainly the Shiller P/E will suggest something very different, that the stock market is significantly overvalued.

But even in that, if you are looking at just the last 20 or 30 years of data, it's kind of in the middle of its range. I'm thinking this might be a time to consider very carefully whether or not the prices we're paying for individual stocks make sense.

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