Valuing Stocks Based on Their Dividend

The subject of valuing stocks by their dividend is discussed in the June AAII Journal, which was posted to our website yesterday. Specifically, Computerized Investing editor Jaclyn McClellan takes an in-depth look at Geraldine Weiss’ approach. I’m going to extend the conversation by discussing Weiss’ and other dividend valuation strategies.

Weiss used a relative valuation approach. Using 10 years of dividend data—20 years when possible—she plotted a stock’s yields to identify its dividend cycle. Doing so alerted her to when yields were high on a historical basis (implying a low valuation) and when yields were low on a historical basis (implying a high valuation). She determined when to buy and sell based on this information. Specifically, she targeted stocks trading within 10% of their historical high yields and sold stocks trading within 10% of their historical low yields.

Those of you who incorporate technical analysis will be familiar with this type of strategy. It is akin to using a stock’s price range or channel. For both relative yield and technical analysis strategies, decisions about the attractiveness of the stock are based on how investors have historically reacted to the stock’s price and valuation movement.

An alternative method is to compare the stock’s yield relative to the universe of exchange-listed stocks. If a stock’s yield is above the market average, it is cheap on a relative basis. If the yield is below the market average, it is expensive. (Yields and valuations are inversely related, with a low yield implying a high valuation and vice versa.) We consider relative yield as part of our approach to managing the AAII Dividend Investing portfolio. Our reason for doing so is because a stock’s yield can be at the high end of its historical range and still be way below the market’s average.

Consider a stock yielding 1.0%. If this stock has historically traded within a high/low range of 1.0% to 0.5%, it looks cheap relative to what investors have been willing to pay in the past. Comparing the stock to the broader market results in a less favorable valuation. The market—as measured by the Dow Jones U.S. ETF (IYY)—currently yields 2.0%. This means an investor can get twice the yield by simply owning a broad market index. Granted, there may be other reasons to own the stock, such as strong earnings growth, but for a dividend-oriented investor, the stock is not very attractive. Hence, when using any valuation strategy, it’s always helpful to take a step back and consider the broader picture.

There is a limit to looking for higher-than-average yields, however. Data from both James O’Shaughnessy and Dartmouth professor Kenneth French show higher yields only lead to higher returns up to a certain point. Why would this be the case? Stocks with the highest yields are those most likely to be perceived as risky by investors. Often, but not always, the perception is justified, with such companies encountering financial problems and hence incurring lower returns.

It’s also possible to value a stock based on the present value of its future dividend payments. To do this, you will need to be reasonably accurate in forecasting what the future dividend stream will be and correctly determine the minimum rate of return you would require to part with your money today in exchange for a future stream of income. Both steps require making assumptions about the company’s growth rate and future interest rates. The likelihood of getting these assumptions wrong is high.

No single approach is perfect. Caveats exist with all valuation methods. Market valuations rise and fall. Business risks change. And while an investor’s short-term perceptions may be very wrong, other times they are justified. Attempts to forecast future returns and growth rates come with their own risks.

One advantage to using a relative valuation approach is its simplicity. Complexity may give an aura of confidence, but it also creates more room for assumptions to be incorrect.