Sunday, November 23, 2008

Don't Overreach For Dividend Yield

(I originally posted this article on The DIV-Net website on November 16, 2008)

The recent decline in equity prices and near record low interest rates, have enticed stock investors to focus on higher yielding dividend paying stocks. One must keep in mind though, a stock's dividend yield is not the same as comparing yields on certificates of deposit.

"After all, if one invests primarily for current income, it might seem logical that stocks with the highest yields would be best. The popularity of the “Dogs of the Dow” approach would seem to support that assumption. However, the Dow Dogs approach is designed to beat major averages through price appreciation; the high yield under that approach is merely an indicator of possible undervaluation."
The stocks that trade at higher yields tend to be the ones that are at the highest risk of a dividend cut. Ideally, stocks with lower yields and the ones that grow the dividend on a regular basis tend to be the type of stock that outperforms the market over the long run.

This year's performance of the high dividend yield approach of the Dogs of the Dow strategy offers some evidence that a high yield approach does not always mean higher total return. The year to date return as of November 21, 2008 for the Dow Dogs equals -50.0% versus the return on the Dow Jones Index of -39.3%.

The dividend-discount model is based on the assumption that dividends ultimately drive share price. If a firm doubles its dividend over a certain time, its stock price should also double if interest rates do not change.

Thus, the percentage rate of dividend growth drives and equals the expected rate of increase in share price. From that equivalence, we can derive this formula for expected percentage total return:

Expected Total Return =
Expected Dividend Growth Rate +
Current Dividend Yield

One event that is occurring with companies and the overall economy is the process of deleveraging. In this environment investors should likely look to invest in those firms that have lower debt levels. The risk of only investing in low debt level firms is when the market/economy improves, leverage can actually enhance a company's earnings, resulting in better performance in a somewhat leveraged company. For those interested, this leverage factor enhances ROE through the equity multiplier as detailed in the Dupont Model.

A few financial measures useful for dividend oriented investors to review are:
  • Common shareholder’s equity as a percentage of total capital
  • Short-term debt as a percentage of total debt (or of total capital)
  • Dividend payout ratio
  • Dividend growth rate
  • Frequency of dividend increases
  • Price-to-book-value ratio
There is no perfect model to use when evaluating dividend paying firms. However, watching the trend in the above factors, like payout ratio, frequency of dividend increase, etc., can provide clues into when a company might be anticipating earnings weakness in the future. Don't simply get trapped buying the highest yielding stocks, then suffer through a dividend cut. Company's that cut their dividend tend to see a contraction in the company's stock price.


Equity Income Investing: Beware of Yield Overreaching ($)
AAII Journal
By: Donald Cassidy
May 1999

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