Financial ratios have value to investors and analysts. But there are also limitations to their usefulness.
Why is Dividend Yield Important?
Dividend yield calculations are important to investors in two different areas.
Fixed Income Investing
Some investors seek investments with a steady income flow. They tend to be the more risk averse, fixed income investors.
The dividend yield of a stock allows them to compare the income stream against fixed income alternatives. That may be other companies that issue dividends. Or it may be other asset classes, such as money market or bond investments.
It also lets them review historic and expected dividend payouts to provide some comfort as to future income streams.
Finally, although locking in a (hopefully) fixed income stream, there is also the possibility for capital appreciation should the share price increase. As with bonds, if general interest rates fall, the price of the shares should rise.
For example, consider Prefco. When general interest rates were 4%, the unique circumstances for the company (earnings potential, competitors, industry, risk, etc.) required that they issue their preferred shares at $50, with a fixed dividend of 5%. This equates to an annual payout of $2.50.
If general interest rates decrease to 3%, there will be an impact on the company’s shares. Probably not an identical impact, but some change. Perhaps the appropriate yield for Prefco based on the lower interest rate is 4%.
As it is pays 5% at $50 per share, investors will buy Prefco as a value play. This will drive the share price up, until it hits $62.50. The price reflecting the new appropriate yield of 4% ($2.50 annual cash dividend divided into $62.50 share price).
Investors who bought shares in the original offering will have unrealized capital gains of $12.50 per share or 25%. Nice if you invested solely for the dividend income. Of course, if interest rates rise, investors may experience unrealized losses.
Value Investing
Value investors seeking capital gains also use dividend yield in their quantitative analysis.
The dividends are nice as they provide a hedge should the shares not appreciate. But the main hope for value shareholders is an increase in share price.
Value investors look for companies with relatively high dividend yields. Relative as compared to benchmark yields, including: company’s history, competitor, industry, sector, stock market. Yields would also be compared to interest rates offered on money market instruments and bonds.
The belief is that high dividend yields results in two possible actions.
One, high dividend yield may indicate the share price is undervalued. Over time, the company’s fortunes will improve and the dividend yield will revert to historic lower levels relative to the benchmark employed as the share price increases.
Two, fixed income seekers will identify the high dividend yield stocks as superior investments versus lower yield alternatives. As the fixed income investors increase demand for shares of the high yield company, the share price will rise, bringing capital gains to the value investor.
As the high dividend yield returns to a lower rate, demand slows and the share price finds equilibrium at a reasonable dividend yield. Reasonable being in line with investor demand based on expectations of the company’s future performance, ability to pay dividends, etc.
The Prefco example above illustrates this principle. The same holds true for common stock (and bonds).
Dividend Yield Limitations
The Past is Not the Future
What transpired in the past is no guarantee of future events.
Dividends are only paid if the company has adequate free cash flow to pay shareholders. Company expansion, new debt issues, dealing with lawsuits are all examples of activities that can erode free cash positions.
Just because a company has made payments in the past does not mean that they will continue in the future. This is especially true concerning common shares. Of less concern are preferred shares, but there is still a risk.
Note that companies do not like to slash or cancel dividends if they historically pay them out. Reducing dividends is usually perceived by investors as negative information about a company’s future results.
Investors like dividend consistency. Companies that fluctuate their payouts are less attractive to investors. This necessitates the company having to increase their dividends, when they do pay them, to entice investors to accept a risk of periods with smaller or no dividends.
High Yields Can be a Negative
Companies with high dividend yields are often mature companies with minimal opportunities for continued operational growth. Because of the limited internal investment possibilities, these companies tend to have high dividend payout ratios.
A dividend payout ratio is the amount of dividends paid to shareholders divided by the net earnings of a company. Companies that payout all their earnings in dividends have a 100% payout ratio. Companies that pay no dividends have 0% payout ratios (100% earnings retention ratio).
High payout ratios are good for those seeking dividend income, less so for those who desire capital appreciation.
Consider a low dividend payout company, or one that does not pay any dividends.
Often these companies prefer to reinvest positive cash flow into growing the business. Purchasing new equipment, conducting research and development of new product lines, spending money to market existing products. Expenditures that work to increase revenues and profits. Which, in turn, should drive share price over time.
Investors believe that the return from cash reinvested in the company’s operations is a better investment than receiving a dividend and investing it elsewhere.
As a value investor, you may see limited capital appreciation in a value stock if there are few opportunities for internal growth and the company distributes its retained earnings to shareholders.
High Yield Indicates Value and Junk
As with low Price/Earnings (P/E) or Price/Book (P/B) ratios, high dividend yields may indicate value in a company’s shares.
But it may also indicate that the shares are worth less than previously thought by investors.
An Example of Limitations
On July 1, Junkco traded at $50 per share and had a trailing dividend yield of 4% (so its annual dividend is $2). This yield was considered reasonable as compared to industry and market averages, as well as to prevailing interest rates offered in the bond and money markets.
On July 10, Junkco announced that it lost a key sales contract that provided 85% of its annual revenue. With no replacement sales available, the share price plunged to $20.
Not good for the company, but great for the dividend yield. It rose to 10%. Much higher than benchmark comparisons.
But does this make the company a value play or a good investment?
If Junkco cannot replace the lost 85% of total revenue, earnings and cash flow will suffer. Junkco may survive this much lost revenue in the short term, but over the long run they will need to scale back their operations or face bankruptcy. Without new sources of revenue, Junkco is definitely not a value stock.
The same warning applies to fixed income investors.
If the original 4% yield was considered reasonable, then at 10% Junkco should be very attractive for dividend seekers.
And if Junkco can replace their revenues, it might be a great deal.
But if they cannot, even in the short term, I would expect Junkco to cancel or severely reduce their dividends. If Junkco reduces the dividend from $2 to $0.50, that would lower the dividend yield to 2.5%. Not a good deal versus the old yield of 4%. And if they cancel the dividend due to lack of cash, that would be even worse for fixed income investors.
Final Thoughts
All quantitative analysis – P/E, P/B, and dividend yield – can be a good indicator of a value investment. But they can also lead investors to see poor investments as having value. Never crunch numbers in isolation.
You must also perform qualitative analysis to separate good from bad. To put the numbers into proper context.
Never ignore the soft side of the analysis and only focus on the numbers.
Avoid the free lunches. If something looks too good, there may be a (negative) reason.
