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February 22, 2020

Yield as a Valuation and Risk Indicator


Yield is commonly viewed from the standpoint of income. It’s a measure of how much cash you can expect to receive from an investment, such as a stock. Yield has other uses, particularly as a measure of valuation and a measure of risk.

An inverse relationship exists between yield and valuation. High yields signal lower valuations whereas low yields signal higher valuations. This is the opposite of many other valuation indicators used by individual investors, such as the price-earnings (P/E) ratio. The difference is due to how both are calculated. In the case of dividends, yield is calculated by dividing dividends by price (D/P). With the price-earnings ratio—and other similar ratios—price appears in the numerator with the calculation being price divided by earnings.

Low valuations have historically been associated with higher returns. Some stocks are cheap for a reason, however. This is where yield’s role as an indicator of risk can come into play. Investors commonly demand a higher yield when they perceive a high level of risk. An elevated yield may simply reflect concerns about future growth or prevailing business conditions. A (very) high yield may signal risk about the company’s ability to continue paying a dividend.

This is why you should not pick a stock on the basis of yield alone. The few extra points of yield you reach for could be more than offset by a drop in the stock’s price. Consider a scenario where you have two stocks, each priced at $100. Stock A has a yield of 2%—a little above the current market yield—while stock B yields 6%. On the surface, stock B’s higher yield might seem attractive, but if its total return (price return plus dividend yield) lags stock A’s total return by a margin greater than four percentage points, you would have been better off holding stock A. It doesn’t take much to tip the scales in favor of stock A.

On the valuation front, a stock’s yield is compared to what investors have historically demanded. A seemingly attractive yield may not be so attractive if it’s well below the five-year average. A lower yield could be attractive if it’s above the five-year average. Consider WEC Energy Group (WEC) and Home Depot Inc. (HD), the latter of which is currently held in the Dividend Investing portfolio. WEC Energy’s current yield of 2.5% compares to a five-year average yield of 3.0%. Home Depot’s current yield of 2.2% compares to a five-year average yield of 1.8%. In this comparison, Home Depot has the cheaper relative valuation even though its absolute yield is lower. WEC Energy was removed from the DI portfolio last year because its yield had fallen to too low of a relative level. It was a case of a good company with an unattractive valuation.

For growth, whether a company has a history of growing its dividend and the intent to continue doing so is looked at. Factors such as sales and earnings growth are also considered. They not only factor into the ability to grow the dividend but also provide a catalyst to drive the stock price higher. For stocks, income is nice but total return is better.

On the fundamental side, the cash flow is paid attention to. A company generating positive cash flow is more valuable than one that isn’t. When cash flow isn’t positive, not only is the dividend at risk but so is the stock’s price. If investors suspect cash flow problems, they’ll demand a higher yield as compensation—preferring to get paid now rather than risk not getting anything in the future. This is why you shouldn’t pick stocks based on yield alone; always dig deeper to determine whether the stock is truly a good bargain.

The Week Ahead
Next week, 41 members of the S&P 500 are scheduled to report earnings. We’ll start to see more retailers announce year-end results, including Dow Jones industrial average component Home Depot on Tuesday.

The week’s first economic reports of note will be the December Case-Shiller home price index and the Conference Board’s February consumer confidence index, released on Tuesday. January new home sales will be released on Wednesday. On Thursday, the first revision to fourth-quarter gross domestic product (GDP) and January durable goods orders will be released. Friday will feature January international trade, January personal income and spending, January core inflation, the University of Michigan’s final February consumer sentiment survey and the February Chicago Purchasing Managers’ Index (PMI).

The Treasury will auction $40 billion of two-year notes on Tuesday, $41 billion of five-year notes on Wednesday and $32 billion of seven-year notes on Thursday.

Courtesy of Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky.   
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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