As we know, investing in dividend paying stocks is more complex than just searching for the highest yield. In fact, we know that high dividend stocks are often priced as such because there is a fundamental problem with the company and the extremely high yield is a signal of significant risk.

In the past we have learned to further investigate dividend yield with a number of factors.

Average Dividend Yield

First off, we like to compare a company’s current dividend yield to the average dividend yield offered by that company over time – 5-10 years is sufficient. The methodology here is to determine where the company is priced in terms of dividend yield based on where the market typically prices the company.

If the current yield is significantly higher than the average yield for that company over time, then it may be a buying opportunity. However, if the yield is extremely higher than the average, it may also be a signal of additional risk – something significant has changed and needs to be investigated.

Dividend Payout Ratio

Secondly, we must determine if the dividend payout ratio is within the normal range for the company. For example, if a company has an average dividend payout ratio of 40% and the current payout ratio is 80% then we must investigate the reasons for the change.

Most dividend paying companies companies have a policy that attempts to maintain a certain percentage of profits that will be paid out as dividends. If the dividend payout ratio moves significantly higher than the stated range, investors may be looking for a dividend cut!

With high dividend stocks, it isn’t uncommon to see dividend payout ratios greater than 100%. Obviously, it doesn’t take a genius to determine that paying out more in dividends than is earned in profits is unsustainable. This is why the examination of the current dividend payout ratio in relationship to the average for the company is a useful exercise.

Examples

To further illustrate the previous points about high dividend stocks and looking beyond the yield, let’s view a couple of examples.

Below is data gathered from Reuters on Proctor & Gamble and Yellow Media Inc.

As we can see, both Yellow Media and Proctor & Gamble offer dividend yields greater than their own 5-year average yields. Both give higher yields than the industry average, and both offer a better 5-year average yield than the S&P 500.

However, on one hand, we have Proctor and Gamble that is currently paying out 48% of profits in dividends, while Yellow Media is paying out, an unsustainable, 1o1.84%.

Perhaps even more importantly is how the payout ratio relates to the dividend growth rate.  If the payout ratio is high, that leaves little (or no) room for reinvestment in the business. If there is no reinvestment into the business, the potential for growth is limited.

As the data indicates, the dividend growth rate over the past five years for PG has averaged 11.81% , while Yellow Media’s dividend has remained essentially flat. If an investor has a long time horizon, the growth of the dividend may be more important than the initial yield.

Of course, there is more to evaluate than average yield and payout ratio when screening for dividend stocks,  but these are two excellent metrics to evaluate when screening for high dividend yields that are sustainable.

Companies with decent average dividend yields and reasonable payout ratios are thought of as reliable and safe investments that offer income as well as an opportunity for capital growth. The dividend growth model reflects how a company has performed in the past.

Since it is just an indicator of past performance, it will not guarantee how a company will do in the future. However, we can only use the information that we have to make an informed investment decision. So, in making an investment, the dividend growth model is a very useful tool for the construction of your portfolio of investments that seek to provide a growing income stream. However, it is not the be all and end all of due diligence that should be performed on a company.

To calculate how much a stock is worth based on the dividend growth model, you will need these three things:

1.)    Current dividend payout of the company

2.)    Growth rate of the dividend

3.)    Your required rate of return.

The current dividend payout and growth rate of a company can be researched online. I like to use Reuters as they display a lot of dividend information along with the other necessary financial information.

Your required rate of return is based on personal requirements for return on your investment capital.

How To Calculate Value Based On The Dividend Growth Model:

1. Add 1 to the dividend growth rate. For example, if the rate is 12%, add 1 to 0.12.
2. Multiply the sum with the current dividend payout. For example, if the payout is $1.50, multiply that by 1.12 to get 1.68.
3. Divide the product, 1.68, by your rate of return less the dividend growth. For example, if your rate if return is 20%, less dividend growth rate of 12% is 8%. Divide 1.68 by 8% or 0.08 and you get $21.

The above example values the stock at $21 based on a 12% dividend growth rate. Compare this value to the most recent closing price of the stock you’re considering. If the closing price is lower, then the model has indicated that this stock has met your criteria and is worthy of further consideration.   

The dividend growth model relies on variables that can change over time and, as such, can only calculate how the stock should be valued at the current dividend growth rate. As we have discovered from the most recent market downturn, dividends do not grow at a constant rate in perpetuity, so the value that we calculate using the dividend growth model can change!

Of course, as with any valuation model, there are risks associated with investing based on purely the dividend growth model. It does, however, provide a good data point for your investment analysis.

To know if the dividend growth rate growth can be sustained for many years, one can also evaluate the sales growth and profit margin trends. As market conditions change, it is useful to continue to run potential investments through the dividend growth model, accounting for changes in dividend growth rate and the dividend payout.

It is very important when investing to not only evaluate a company against others in its sector or industry, but also against itself.

In previous articles, we have discussed the dividend payout ratio, free cash flow, Z-Score and Return on Invested Capital (ROIC). All of these metrics are used as a way to evaluate stocks against their peer group, but also against themselves at different points in time.

When we have narrowed a company down against its peers, it is then time to evaluate the stock against itself at different points in time. Doing this can help us to determine if a stock is selling at a reasonable price.

How To Use Average Dividend Yield 

One of the greatest ways to evaluate a dividend stock against itself is to determine the average dividend yield that that stock has paid over the past number of years. If the stock has a higher than average yield, compared to its own historical average, then it may indicate that it is a better time to purchase shares (all other factors being equal).

There is an excellent tutorial on calculating average dividend yield at DividendsMatter.com. I will highlight some of the main points here, but I highly suggest that you read the full tutorial.

First of all, I like to gather 10 years worth of data for the stock. This is easy to do because the stocks that I analyze have very long histories of paying dividends. The information we need is the high and the low stock price, and the dividend paid out for each of the last 10 years.

This data can be gathered from many sources, including the company website.  However, I prefer to use Yahoo Finance because the dividend information can be filtered out from the stock price using this option.

This is all the historical information we need. Now, from this information, we can calculate the high yield and the low yield for each year. The high yield is calculated by taking the annual dividend and dividing by the low price. Similarly,the low yield is calculated by taking the annual dividend and dividing by the high price.

High Dividend Yield = Annual Dividend / Low Stock Price

Well Worth The Effort 

The mathematics of the process is very elementary, but it does take some time to gather the information.  This is certainly time well spent and I suggest that you practice on a couple of your favorite stocks. 

You will find that buying high quality, dividend growth stocks at prices above their average dividend yield will give you a margin of safety and confidence to hold the stock through thick and thin.

Obviously, this is one metric of many that will help guide you in your quest to buy quality dividend growth stocks. 

Please see: How To Choose Dividend Growth Stocks . for additional learning.

Even though the yield on Treasuries is at historically low levels, investors are willing to sacrifice the returns they need for the sense of security they want. Unfortunately, this fixation with ‘safe’ assets doesn’t make much sense within the context of long-term goals.

Let us now look at the other side of the Treasuries phenomenon. In their quest for certainty, many investors may be unwittingly ignoring dividend yields on stocks, which have become more compelling as a result of the downturn in global markets.

The Dividend Yield

As dividend investors, we have recently noticed that the dividend yield on the S&P 500 Index is greater than the yield on U.S. Treasury bonds for the first time in 50 years!

Case in point, the dividend yield on the S&P 500 as of the end of November was about 3% versus the yield on the 10-year Treasury which today, is about 2% (the 2-year Treasury is yielding about 0.70%). What’s more, this isn’t just a U.S. phenomenon. In Europe, the yield on stocks also currently exceeds the yield on government bonds.

Of course, dividends are a key part of total returns (price appreciation plus investment income, including dividends).  The fact that dividend yields are high relative to Treasury yields right now makes the case for dividend-paying companies that much more compelling.  

If we look back to the period between 1974 and 1982, the performance of the S&P 500 was sluggish on a price return basis.  But if you look at what happened as markets began to recover, including dividends in the returns that investors earned as they emerged from a period of economic uncertainty and capital market weakness (i.e. looking at total return) made a significant difference.

Herding To Safety

Today, the desire for safety runs the risk of driving ‘the herd’ off the edge of the proverbial cliff as people abandon their long-term goals in favor of short-term stability. But despite what the headlines might suggest, the world isn’t two- dimensional.

That is to say it’s not just risky assets or safe assets. To see the total picture, including why dividends need to be a key consideration in the investment process, is a starting point to having better, more robust conversations in today’s uncertain environment.