Value investors are always seeking undervalued stocks to add to their portfolios while pruning those that are overvalued. However, a stock’s price doesn’t always reflect a company’s true value. The dividend yield is a useful measure of value for selecting undervalued securities and pruning overpriced stocks from your portfolio. A stock’s dividend yield is computed by taking the indicated dividend—the expected dividend payment over the next year—and dividing it by the share price.
Value investors are drawn to stocks with high yields, provided the dividend payment is secure. As investors begin purchasing shares, the dividend yield’s denominator (price) increases, driving down the ratio. Once the price appreciation causes the yield to decline, income investors begin selling the stock because it is no longer attractive on a dividend-yield basis.
Like the price-earnings ratio, the dividend yield attempts to highlight stocks that are out of favor. Contrarian techniques such as this are based upon the premise that markets tend to overreact to good or bad news and push the price of a stock away from its intrinsic value. Investors try to identify these mispriced stocks through a set of rules called a valuation model. Valuation models give you a framework to analyze a stock and ask relevant questions—a process that helps to keep your emotions in check.
Analyzing Yield on a Relative Basis
Absolute or relative yields may be used to measure value, but we find that relative yield analysis works better over a range of market environments. An absolute test might require a minimum yield of 4% before you would consider buying a stock. Absolute requirements could lead to passive market timing, as you build up cash levels when you cannot find suitable investments that meet the minimum yield requirement during market extremes. Absolute requirements will also typically push your portfolio into a few industries that traditionally trade with higher dividend yields, such as utilities.
Relative yield models examine the historical relationship of a stock’s yield with a benchmark. It is common to compare a stock’s dividend yield to the overall market yield, the industry yield, the company’s own historical average yield or even against an interest rate benchmark. These benchmark yields will fluctuate, but you would be concerned if the stock’s normal relationship to the benchmark has deviated significantly. If a stock has normally traded with a yield above the market average and now trades with a yield well below that of the market, it may indicate that the stock is overvalued. We require that a stock’s yield be above the yield of the Dow Jones U.S. Index ETF (IYY) when adding a stock to the DI portfolio. Currently, the yield on the overall U.S. stock market is approximately 1.7%.
Comparing a stock’s yield to its own historical average can be a very revealing test. A deviation from the normal average can point to a mispriced stock or highlight that a fundamental shift has occurred with the company’s prospects. Firms with high dividend yields normally have lower capital appreciation potential—their earnings are expected to grow at slower rates. A growing dividend may signal that that firm is past its explosive growth and capital-intensive stage. The company is generating excess cash that is not needed to fund internal expansion. Firms increase dividends only when they feel confident of the ability to maintain the new level. Decreasing or eliminating a dividend is tantamount to announcing to the investment community that the firm is in trouble, a situation that firms would like to avoid. So, an increase in the annual cash dividend is a strong, positive statement by the firm that it believes future earnings, liquidity and financial position warrant the dividend increase.
Calculating Average Yields
When calculating the average yield, the first issue revolves around which time period to use for the calculation. Selecting a time period is a balance between avoiding one that is too short and only captures a partial segment of the market cycle and one that is too long and includes a time period that is no longer representative of the current company, industry or market. Periods between five and 10 years are most common for these types of comparisons.
Even greater insight can be gained by looking at the year-by-year dividend yields and calculating the annual high-low range. The low yield for a given year is determined by dividing the dividends paid during the year by the high stock price during the calendar year, while the high yield is calculated using the low price during the year. These high and low yields can be thought of as a valuation trading range that is driven by both dividend and price changes. Yields near or below the five-year average low yield imply the stock is overvalued relative to its historical norm. Yields near or above the five-year average high yield imply that the stock may be undervalued relative to its historical norm.
One Piece of the Picture
Comparing a stock’s current yield to relative benchmarks is based upon the time-honored rule of buying low and selling high. The relative yield models provide a useful framework to measure valuations, but one must look at the complete picture.
Adapted from the June 2017 AAII Dividend Investing newsletter.