Yield's Role as a Valuation and Risk Indicator

Yield is commonly viewed from the standpoint of income. It’s a measure of how much cash you can expect to receive from an investment, such as a stock. Yield has other uses, particularly as a measure of valuation and a measure of risk.

An inverse relationship exists between yield and valuation. High yields signal lower valuations whereas low yields signal higher valuations. This is the opposite of many other valuation indicators used by individual investors, such as the price-earnings (P/E) ratio. The difference is due to how both are calculated. In the case of dividends, yield is calculated by dividing dividends by price (D/P). With the price-earnings ratio—and other similar ratios—price appears in the numerator with the calculation being price divided by earnings.

Low valuations have historically been associated with higher returns. Some stocks are cheap for a reason, however. This is where yield’s role as an indicator of risk can come into play. Investors commonly demand a higher yield when they perceive a high level of risk. An elevated yield may simply reflect concerns about future growth or prevailing business conditions. A (very) high yield may signal risk about the company’s ability to continue paying a dividend.

This is why you should not pick a stock on the basis of yield alone. The few extra points of yield you reach for could be more than offset by a drop in the stock’s price. Consider a scenario where you have two stocks, each priced at $100. Stock A has a yield of 2%—a little above the current market yield—while stock B yields 6%. On the surface, stock B’s higher yield might seem attractive, but if its total return (price return plus dividend yield) lags stock A’s total return by a margin greater than four percentage points, you would have been better off holding stock A. It doesn’t take much to tip the scales in favor of stock A.

Of course, the challenge is determining which stock will perform better. For AAII’s Dividend Investing (DI) portfolio, this is done by considering a stock’s relative yield, the likelihood of it continuing to grow its dividend and its underlying financial strength. Combined, all three pillars indicate whether the current yield reflects a bargain or a risky stock that should be passed up.

On the valuation front, a stock’s yield is compared to what investors have historically demanded. A seemingly attractive yield may not be so attractive if it’s well below the five-year average. A lower yield could be attractive if it’s above the five-year average. Consider WEC Energy Group (WEC) and Home Depot Inc. (HD), the latter of which is currently held in the Dividend Investing portfolio. WEC Energy’s current yield of 2.5% compares to a five-year average yield of 3.0%. Home Depot’s current yield of 2.2% compares to a five-year average yield of 1.8%. In this comparison, Home Depot has the cheaper relative valuation even though its absolute yield is lower. WEC Energy was removed from the DI portfolio last year because its yield had fallen to too low of a relative level. It was a case of a good company with an unattractive valuation.

For growth, whether a company has a history of growing its dividend and the intent to continue doing so is looked at. Factors such as sales and earnings growth are also considered. They not only factor into the ability to grow the dividend but also provide a catalyst to drive the stock price higher. For stocks, income is nice but total return is better.

On the fundamental side, the cash flow is paid attention to. A company generating positive cash flow is more valuable than one that isn’t. When cash flow isn’t positive, not only is the dividend at risk but so is the stock’s price. If investors suspect cash flow problems, they’ll demand a higher yield as compensation—preferring to get paid now rather than risk not getting anything in the future. This is why you shouldn’t pick stocks based on yield alone; always dig deeper to determine whether the stock is truly a good bargain.