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.