Tuesday, April 2, 2013

Stock Valuation Method - Average Dividend Yield

We all want to be able to assign a fair value to a stock to determine what price we should pay for a share iof a potential investment.  This is the 2nd post in my series on different stock valuation methods.  I've previously covered the Graham Number and today will examine the average dividend yield method.

The average dividend yield method is fairly easy to understand and is simply based on the historical range that a companies dividend yield has traded in.  Yahoo! Finance provides a 5 year average dividend yield on the key statistics tab of all the companies listed.  The average yield provided here is the overall average, but it tells you nothing as far as the full range that it typically is in.  It's a nice start, but doesn't really give you a full picture.

If you want some more detail then it's going to require some homework to gain more information.  To cut down on the numbers that I need to look up, I take the dividends paid per share during each fiscal year and use the stock price history to get the high and low prices that the shares traded for during the fiscal year.  In my analyses, I gather 10 years worth of data so I can calculate the 5 and 10 year ranges.  A more detailed analysis would be to do this on a quarterly basis since nothing says a company has to  increase their dividend starting with the first quarter of each fiscal year.  However, this increases the amount of data that you need to look up by three-fold.  I feel that using the fiscal year dividends and high/low prices gives an adequate enough picture.

Once you've gathered all the information, you simply take the dividends paid out during each fiscal year and divide that by the low price to get the high dividend yield and then by the high price to get the high dividend yield.  After you've done this for all the years that you have data on, then it's a straight average of the last 5 years of high and low dividend yields, and if you've gathered 10 years of data then also average the 10 year yields.

Now that you have the 5 and 10 year averages for the high and low dividend yields, you then divide the current annual dividend payment by each of the yields.  This will give you the price per share that each yield represents.  For example, say the 5 year low yield was 2% and the 5 year high yield was 3%.  If the current annual dividend payment for a company is $1.00 per share, you would take $1.00 / 2% = $50.00, this would be the low dividend yield price.  The high dividend yield price is calculated as $1.00 / 3% = $33.33.  You now have a range of prices with the high dividend yield corresponding to a lower price and therefore a lower valuation.

In theory a company that increases its dividend year in and year out will see an increase in the share price to bring the yield to a more realistic level.  This is why you don't see companies trading for 20%+ dividend yields.  If you can purchase closer to the high end of the typical dividend yield range you will be buying in at a lower valuation.

As I've mentioned before, just one valuation method can't give you a complete picture on whether a company is trading at an attractive price.  This is why it's best to use to several different methods in order to get a range of fair prices.

3 comments:

  1. Thanks for writing up this valuation method. I'll have to try adding it to my valuation panel and seeing if it provides any new insights.

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    1. MyFIJ,

      No problem. I like looking at this because it can show where it's typically trade or the typical range that the yield has fluctuated through. Obviously there's times when it isn't that telling either due to extreme over valuation (2000) or under valuation (2009), but I still find is pretty useful. It's a more telling metric for the mega caps that already pay a sizeable dividend, if it's a really fast dividend grower the yield will typically climb but you'll still see it trade within a range that's usually skewing higher.

      Thanks for stopping by!

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  2. I would just like to say something about value stock selection. Their is a simple method to determine if a stock is a really great value. Its known as the price to sales ratio. Very few investors are even aware of what this ratio is or what it means. Thats unfortunate because this valuation metric could very well be the very most important factor in determining whether or not you are hugely successful as a stock value investor. I will challenge anyone to find any valuation metric that is superior to the price to sales ratio. I will give everyone a perfect example of how this valuation metric works and the reasone for its enormous importance to value stock investors.

    The company I will use as a example is Amerisource Bergen Corporation (ABC) The price to sales ratio of this stock is 0.15 thats means that the market cap of the stocks is 12 billion dollars thats the value of all the shares outstanding multiplied by their current market price. Now this is a company that does 80 billion dollars in sales on a annual basis so the value the market is placing on this company is just 12 billion dollars. Now I think everyone is now getting a much clearer picture of why the price to sales ratio is so very important. The company by the way is a pharmaceutical services company, provides drug distribution and related healthcare services and solutions to pharmacy, physician, and manufacturer customers primarily in the United States and Canada. Their profit margain is very small only 1% of annual sales but because of their economy of scale that could improve significantly over time just a doubling of their profit margains to 2% instead of 1% would not seem all that diffcult for a high quality well run company like Amerisource Bergen to achieve over time. Because their in a sector of the economy thats growing at a much faster rate than the economy in general their annual sales have been growing at close to ten percent a year and will most likely continue to do so. In addition to this the company pays a dividend and because of the companies strong balance sheet they could easily buyback a third of their stock outstanding over time without having a negative effect on the companies performance the total value of all the companies shares outstanding remember is just 12 billion dollars the company also has very little debt for example and very positive cash flow. If the company were to achieve all these objectives over a seven year period and the shares of the companies stock were to trade at 20 times earnings that would put the price of the stock which currently trades around 52 dollars a share at over 400 dollars a share that does not count reinvesting the dividends. If anyone has any doubt at all as to the validity of the material presented feel free to check it out yourself or to have a investment professional check it out for you. You will find everything presented here to be 100% accurate.

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