The two major payroll processing companies in the United States, Automatic Data Processing (NASDAQ:ADP) and Paychex, Inc. (NASDAQ:PAYX) are darlings of the income investor community. Both companies provide a critical service that nearly all companies need, and they pay their investors solid dividend yields that exceed the yield on the broader market.
While Automatic Data Processing (NASDAQ:ADP) and Paychex, Inc. (NASDAQ:PAYX) provide new investors with dividend yields of 2.4% and 3.4%, respectively, which is higher than the roughly 2% currently available on the S&P 500 Index, it’s getting extremely difficult to consider these stocks cheap. It goes without saying that both stocks are extremely well-known among income investors. That being said, it’s important to consider dividend yields within the context of total return potential. And, considering the levels where these two stocks are trading, it’s far from certain that the total return potential for Automatic Data Processing (NASDAQ:ADP) and Paychex, Inc. (NASDAQ:PAYX) is compelling enough to warrant new investment.
Decent dividends: is that enough?
Income investors are understandably hungry for yield, since interest rates are at historic lows in an attempt to juice the slow-growing economy. Because of that, it’s reasonable to consider securing the dividends offered by Automatic Data Processing (NASDAQ:ADP) and Paychex, Inc. (NASDAQ:PAYX).
ADP’s financial position is strong, thanks to a very healthy balance sheet. ADP remains one of only four non- financial U.S. companies rated AAA by both leading credit rating agencies. In addition, the company is clearly committed to rewarding shareholders. In 2012, ADP increased its dividend 10%, raising its distribution for the 38th year in a row. Automatic Data Processing (NASDAQ:ADP) also bought back nearly $750 million in stock last year.
Paychex, Inc. (NASDAQ:PAYX) offers a higher dividend than ADP, yielding about one hundred basis points more, but not much room for dividend growth. The company paid out 84% of its diluted earnings per share to investors in 2012. Furthermore, the company has raised its regular common stock dividend only twice since 2009, and on each occasion, the distribution increase was only one penny per share.
It’s rarely advisable to buy a stock just for its yield. While Automatic Data Processing (NASDAQ:ADP) and Paychex are profitable companies, their growth leaves a lot to be desired. Especially in the case of Paychex, Inc. (NASDAQ:PAYX), which has offered investors little growth in its distribution over the past few years, investors would be wise to take these stocks’ valuations into consideration.
Lofty valuations a cause for concern
ADP recently reported a solid fiscal third quarter, in which revenue and earnings per share from continuing operations increased 7% and 9%, respectively. Taking a longer-term view, the company’s revenue and diluted earnings per share have grown 6% and 5.7%, respectively, through the first nine months of the fiscal year.
Those numbers are certainly respectable, but judging by its immense share price appreciation, you’d think ADP was a high-growth start-up. The stock is up more than 25% just to start 2013, and as a result, the company now trades for 25 times its trailing earnings per share.
Paychex has a similar story to tell, since it also trades for 25 times trailing earnings thanks to a 24% rally in the company’s share price since the beginning of the year. Paychex’s third quarter results compared similarly to ADP: the company realized 4% growth in total service revenue and 8% growth in diluted earnings per share.
As I mentioned before, these two companies are well-managed and highly profitable. But when you consider the lofty valuations these companies enjoy, due to their huge run-ups in price over the past few months, and you have more than enough reason to hesitate before jumping in to these stocks. Savvy investors would be wise to wait for a meaningful pullback before buying these two stocks.
The article These Two Industry Leaders Are Fully Valued originally appeared on Fool.com is written by Robert Ciura.
Robert Ciura has no position in any stocks mentioned. The Motley Fool recommends Automatic Data Processing and Paychex. Robert is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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