Dividend Yield

On 09/03/2010, in Equities, Investment Strategies, by Jordan Wilson
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Another ratio used by value investors, as well as seekers of cash flow, is the dividend yield.

Whereas value investors seek companies with relatively low price-to-earnings (P/E) and price-to-book (P/B) ratios, they desire companies with high dividend yields.

Today we will look at the dividend yield.

What is Dividend Yield?

There are two ways to think about dividend yield.

First, dividend yield is an indicator of how much annual cash flow an investment generates.

If you own an investment that yields 10% per annum, you know how much cash flow you will receive each year. If you invest $100, you will receive $10 each year.

Second, the dividend yield indicates the payback period on an investment.

That is, how much time is required for repayment of your initial capital. If you invest $1000 in a company with a 10% annual dividend, you will recover your original $1000 in 10 years.

A good analytical tool if you are concerned about the safety of the investment.

Calculating the Dividend Yield

Dividend yield is calculated by taking the amount of dividends paid annually divided by the current share price.

Unless the dividend is increased or decreased by the company, the yield will be constant for existing shareholders.

For example, ABC company pays a steady $1 per year dividend. You bought 100 shares at $12 per share. Your sister bought 200 shares at $8 per share and your brother bought 500 shares at $15 per share.

You will receive $100 in dividends annually with a yield of 8.3%. Your sister will receive $200 annually. But because she bought at a lower share price, her dividend yield is 12.5%. And your brother will receive $500 in dividends each year. However, as he bought his shares at $15 each, his dividend yield is only 6.7%.

Note that some companies pay dividends in terms of percentage payouts. Do not confuse this with the yield. The dividend yield is based on the price you paid for the shares. The stated percentage dividend is based on the share’s par value at issue.

For example, Fixedco issues A Class Preferred Shares at $100 par value with a fixed 6% annual dividend. For each share you own, you receive 6% of the par value. In this example, $6.

If you purchased the shares at $150 each, you will still receive 6% of the par value, not 6% of your purchase price. You will earn $6 annually and your dividend yield will be 4%.

Dividend Yield and Share Price

Assuming a fixed dollar or fixed percentage dividend, investors’ yields will vary dependent on when they purchase the shares. Fixed rate dividends are usually seen in preferred shares.

If investors paid more than the par or issued value for the shares, their yields will be lower than the original fixed yield.

If they paid less than par or issue value, they will receive a higher yield.

We saw this in the examples above.

If the dividend paid varies over time, as is the case of most dividend paying common shares, then a shareholder’s dividend yield will also vary.

Analytical Considerations

As with price-to-earnings, investors consider dividend yields based on actual payouts (e.g. previous year, 5 year average, etc.) and on on expected future payouts.

If assessing whether to invest in shares, I suggest comparing the expected future yield against the 5 year average payout to determine any trend of increasing or decreasing the dividend.

I would also remove any extraordinary or special dividends from my comparative data.

These dividends are paid only on special occasions and are not recurring in nature. Excluding them from the analysis allows for better comparison with normal dividend payments.

I would also review the company’s dividend history.

Have prior year dividends been stable or increasing in amount? Or have there been periods when dividends were reduced or not paid? If the former, there is more comfort that future dividend streams will continue. If the latter, the risk of reduced future income rises.

Why is Dividend Yield Important?

Dividend yield calculations are important in two different areas.

Fixed Income Investing

Some investors seek investments with a steady income flow. They tend to be the more risk averse, fixed income investors.

The dividend yield of a stock allows them to compare the income stream against fixed income alternatives, such as money market or bond investments.

It also lets them review historic and expected dividend payouts to provide some comfort as to future income streams.

Finally, although locking in a (hopefully) fixed income stream, there is also the possibility for capital appreciation should the share price increase.

As with bonds, if general interest rates fall, the price of the shares should rise.

As an example, consider Prefco. When general interest rates were 4%, the unique circumstances for the company (earnings potential, competitors, industry, risk, etc.) required that they issue their preferred shares at $50, with a fixed dividend of 5%. This equates to an annual payout of $2.50.

If general interest rates decrease to 2.5%, there will be an impact on the company’s shares. Probably not an identical impact, but some change. Perhaps the appropriate yield for Prefco based on the lower interest rate is 4%.

As it is paying 5% at $50 per share, investors will buy Prefco as a value play. This will drive the share price up, until it hits $62.50. That is the price that reflects the new appropriate yield of 4% ($2.5 annual cash dividend divided into $62.50 share price).

Had a fixed income investor bought shares during the original offering, he will have an unrealized capital gain of $12.50 per share or 25%.

Value Investing

Value investors seeking capital gains also use dividend yield in their quantitative analysis.

The dividends are nice as they provide a hedge should the shares not appreciate. But the main hope for value shareholders is an increase in share price.

Value investors look for companies with relatively high dividend yields. Relative as compared to benchmark yields, including: company, competitor, industry, sector, stock market. Yields would also be compared to interest rates offered on money market instruments and bonds.

The belief is that high dividend yields results in two possible actions.

One, the high dividend yield may indicate that the share price is undervalued. Over time, the company’s fortunes will improve and the dividend yield will revert to historic lower levels relative to the benchmark employed as the share price increases.

Two, fixed income seekers will identify the high dividend yield stocks as superior investments versus lower yield alternatives.

As the fixed income investors increase demand for shares of the high yield company, the share price will rise, bringing capital gains to the value investor.

As the high dividend yield returns to a lower rate, demand slows and the share price finds equilibrium at a reasonable dividend yield. Reasonable being in line with investor demand based on expectations of the company’s future performance, ability to pay dividends, etc.

The Prefco example above illustrates this principle.

Dividend Yield Limitations

The Past is Not the Future

What transpired in the past is no guarantee of future events.

Dividends are only paid if the company has adequate free cash flow to pay shareholders.

Company expansion, new debt issues, dealing with lawsuits are all examples of activities that can erode free cash positions.

Just because a company has made payments in the past does not mean that they will continue in the future. This is especially true concerning common shares. Of less concern are preferred shares, but there is still a risk.

Note that companies do not like to slash or cancel dividends if they historically pay them out.

Investors like dividend consistency. Companies that fluctuate their payouts are less attractive to investors. This necessitates the company having to increase their dividends, when they do pay them, to entice investors to accept a risk of periods with smaller or no dividends.

High Yields Can be a Negative

Companies with high dividend yields are often mature companies with minimal opportunities for continued operational growth.

Because of the limited internal investment possibilities, these companies tend to have high dividend payout ratios.

A dividend payout ratio is the amount of dividends paid to shareholders divided by the net earnings of a company. Companies that payout all their earnings in dividends have a 100% payout ratio. Companies that pay no dividends have 0% payout ratios (100% earnings retention ratio).

High dividend payout ratios are good for those who seek dividend income, but less so for those who desire capital appreciation.

Consider a low dividend payout company, or one that does not pay any dividends.

Often these companies prefer to reinvest positive cash flow into growing the business. Purchasing new equipment, conducting research and development of new product lines, spending money to market existing products.

Investors believe that the return from cash reinvested in the company’s operations is a better investment than receiving a dividend and investing it elsewhere.

So as a value investor, you may see limited capital appreciation in a value stock if there are few opportunities for internal growth.

High Yield Indicates Value and Junk

As with low P/E or P/B ratios, high dividend yields may indicate value in a company’s shares.

But it may also indicate that the shares are worth less than previously thought by investors.

An Example of Limitations

On July 1, Junkco traded at $50 per share and had a trailing dividend yield of 4% (so its annual dividend was $2). This yield was considered reasonable as compared to industry and market averages, as well as to prevailing interest rates offered in the bond and money markets.

On July 10, Junkco announced that it lost a key sales contract that provided 85% of its annual revenue. With no replacement sales available, the share price plunged to $20.

Not good for the company, but great for the dividend yield as it rose to 10%. Significantly higher than benchmark comparisons.

But does this make the company a value play?

If Junkco cannot replace the lost 85% of total revenue, then earnings and cash flow will both suffer. Junkco may survive this much lost revenue in the short term, but over the long run they will need to scale back their operations or face bankruptcy.

Without new sources of revenue, Junkco is definitely not a value stock.

The same warning applies to fixed income investors.

If the original 4% yield was considered reasonable, then at 10% Junkco should be very attractive for dividend seekers.

And if Junkco can replace their revenues, it might be a great deal.

But if they cannot, even in the short term, I would expect Junkco to cancel or severely reduce their dividends. If Junkco reduces the dividend from $2 to$0.50, that would lower the dividend yield to 2.5%. Not a good deal versus the old yield of 4%. And if they cancel the dividend due to lack of cash, that would be even worse for fixed income investors.

Final Thoughts

All quantitative analysis – P/E, P/B, and dividend yield – can be a good indicator of a value investment. But they can also lead investors to see poor investments as having value.

You always need to do qualitative analysis to separate the good from the bad. To put the numbers into their proper context.

Try not to ignore the soft side of the analysis and only focus on the numbers.

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