The subject of valuing stocks by their dividend is discussed in the June AAII Journal , which was posted to our website yesterday. Specifically , Computerized Investing editor Jaclyn McClellan takes an in-depth look at Geraldine WeissAAA approach. IAAAm going to extend the conversation by discussing WeissAAA and other dividend valuation strategies.
Weiss used a relative valuation approach. Using 10 years of dividend dataAAA20 years when possibleAAAshe plotted a stockAAAs yields to identify its dividend cycle. Doing so alerted her to when yields were high on a historical basis (implying a low valuation) and when yields were low on a historical basis (implying a high valuation). She determined when to buy and sell based on this information. Specifically, she targeted stocks trading within 10% of their historical high yields and sold stocks trading within 10% of their historical low yields.
Those of you who incorporate technical analysis will be familiar with this type of strategy. It is akin to using a stockAAAs price range or channel. For both relative yield and technical analysis strategies, decisions about the attractiveness of the stock are based on how investors have historically reacted to the stockAAAs price and valuation movement.
An alternative method is to compare the stockAAAs yield relative to the universe of exchange-listed stocks. If a stockAAAs yield is above the market average, it is cheap on a relative basis. If the yield is below the market average, it is expensive. (Yields and valuations are inversely related, with a low yield implying a high valuation and vice versa.) We consider relative yield as part of our approach to managing the AAII Dividend Investing portfolio. Our reason for doing so is because a stockAAAs yield can be at the high end of its historical range and still be way below the marketAAAs average.
Consider a stock yielding 1.0%. If this stock has historically traded within a high/low range of 1.0% to 0.5%, it looks cheap relative to what investors have been willing to pay in the past. Comparing the stock to the broader market results in a less favorable valuation. The marketAAAas measured by the Dow Jones U.S. ETF ( IYY )AAAcurrently yields 2.0%. This means an investor can get twice the yield by simply owning a broad market index. Granted, there may be other reasons to own the stock, such as strong earnings growth, but for a dividend-oriented investor, the stock is not very attractive. Hence, when using any valuation strategy, itAAAs always helpful to take a step back and consider the broader picture.
There is a limit to looking for higher-than-average yields, however. Data from both James OAAAShaughnessy and Dartmouth professor Kenneth French show higher yields only lead to higher returns up to a certain point. Why would this be the case? Stocks with the highest yields are those most likely to be perceived as risky by investors. Often, but not always, the perception is justified, with such companies encountering financial problems and hence incurring lower returns.
ItAAAs also possible to value a stock
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