Stock Dividends
Using Dividend Yield to Identify Stock Bargains
stocks dividends
Question: Can dividend yields help you find bargains in the stock market? You all know what dividends are: Cash payments by companies to their shareholders out of company profits. Dividend yield is a simple calculation from two pieces of information: Total dividends over the past twelve months divided by the stock’s current price. So if Dividend Co. pays $1-per-share annual dividend, and today’s price is $40, its current yield is 1/40, or 2.5%. Every stock’s current yield is readily available on every financial Web site and in the newspaper.
Current yields change daily. The yield changes any time either of its two components changes. Most dividends are paid quarterly, so most changes in that piece–the annual dividend–happen just four times per year.
But the stock’s price changes continually whenever the market is open. If Dividend Co.’s price goes up to $41 today, its current yield drops to 2.4% (1/41). Companies in certain sectors–such as finance and energy–have become known for paying healthy dividends. Well, there is an entire investment strategy called Dogs of the Dow based on the proposition that the highest-yielding stocks in the Dow Jones Industrial Average at any given time represent the best bargains. A popular technique is to invest in the ten highest-yielding Dow stocks (the “Dogs”), hold them for a year, then sell them and buy the new ten highest yielding stocks. I found that in using dividends to identify bargains, you must look beyond the yield itself. It so happens that financial stocks right now illustrate the point perfectly. At the end of last year, it had a sky-high yield of 7.3%. Most of the time, a high-yielding stock suggests a good bargain. The latter two have delivered both high yields and decent price appreciation, while JP Morgan Chase has suffered much less than many other financial stocks.
Bottom line: High yields can be a good starting point in locating bargains. But look beyond yield alone. Ask yourself if the dividend is in jeopardy: For example, is it way high compared to what the stock normally yields?
Four Qualities of the Best Dividend Stocks
Initial Yield:
An ideal dividend stock ought to start off with a decent yield. Higher yield helps compensate for the risk of owning a stock, whose price is never guaranteed or insured.
That said, some leeway can be granted on the initial yield, because the best dividend stocks increase their dividends regularly. My personal requirement for the minimum initial yield from a dividend stock is 2.5%. I will go as low as 1.9% for “Dividend Aristocrats,” a term used by Standard & Poor’s for their list of stocks that have raised their dividends at least 25 consecutive years.
Consistency and Safety of Dividend Payments:
The second characteristic is consistency. There is no way to guarantee the future, of course, but we can draw reasonable inferences from past performance, current conditions, and intelligent projections. So, we want a company that displays:
- Uninterrupted payment of a dividend for at least several years.
- A sustainable payout ratio. (The “payout ratio” is the percentage of earnings that the company is directing to dividends rather than retaining for reinvestment in the company.)
- A steady history of raising its dividend most (if not all) years.
- No severe financial difficulties that seem to threaten the dividend.
- An explicit statement from management that they are determined to pay and periodically increase the dividend. Or, lacking that, an implied intention based on the historical record plus current management statements that underscore the importance of the dividend.
Dividend Growth:
The third quality of an ideal dividend stock is dividend growth. It is a company’s ability to grow its dividend that separates it from “fixed income” investments like bank accounts and bonds.
As stated earlier, high current yield and steady dividend growth do not necessarily go together. Some companies increase their dividends infrequently or erratically. Other companies increase their dividends regularly, but they don’t pay out very much of a dividend. So we must examine dividend growth separately from the size of the dividend.
The fourth important factor in a great dividend stock is its potential to appreciate in price.
This is another advantage that dividend-paying stocks have over bank deposits and bonds. Some investors believe that a dividend stock’s price rises because of its dividend and increases to it. Let’s just say that the stock’s dividend history is one factor that many investors consider in deciding a fair price to pay. Depending on your personal goals, you may care a lot or just moderately about a dividend stock’s price growth potential.
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