E Using Average Dividend Yield For Dividend Growth Stock Valuation

Dividend growth investing focuses on investing in businesses with a strong track record of rewarding shareholders through ever-increasing dividend payments. I consider dividend growth stocks to be stocks that have paid higher dividends for at least 5 consecutive years.

Finding high-quality dividend growth stocks is an important part of dividend growth investing. But investing in such stocks when their prices are inflated, is not a sound investment strategy. For this reason, I use various stock valuation methods to find undervalued stocks.

A quick method is to use a stock's historical average dividend yield. If the stock is of a stable business that regularly pays and raises its dividends, the stock's dividend yield will tend to revert to its historical average dividend yield over time. And the stock price corresponding to the historical average dividend yield will be a reasonable estimate of fair value for the stock.

Dividend Yield

Dividend yield is defined as a stock's annual dividend expressed as a percentage of the current stock price:

yield = 100 × annual dividend / stock price

The current stock price is the last price at which the stock traded, but what is the annual dividend? Except for companies that pay annual dividends, the term annual dividend is unclear. We can annualize monthly, quarterly or semi-annual dividends, but over which period?

Arguing there is no guarantee that future dividends will match past dividends, some analysts prefer to use only paid dividends in yield calculations. Variations include the total dividends paid in the last calendar year, the last fiscal year, or the trailing twelve months. A dividend yield calculated this way is called the trailing dividend yield.

For dividend growth stocks (as defined above), I expect future dividends to continue to exceed past dividends. Therefore, I annualize either the last paid dividend or an announced increased dividend to calculate dividend yield. A dividend yield calculated this way is called the forward dividend yield.

In my view, trailing dividends are misleading because they do not account for dividend increases or cuts. Forward dividends represent the best available information at the time of calculation. Note there is an inverse relationship between dividend yield and stock price. If the stock price increases, the dividend yield decreases, and vice versa. Here is a 5-year price and yield chart of Johnson & Johnson (JNJ), clearly showing this inverse relationship:

In August 2015, JNJ's dividend yield topped out at 3.31% when the stock price dropped to $90.73 per share. Conversely, in January 2018, JNJ's dividend yield bottomed out at 2.27% when the stock price climbed to $148.14 per share. 

Average Dividend Yield

The average dividend yield of JNJ over the last 5-years is 2.72%.

Looking at the chart of JNJ, when the dividend yield is much higher than the average dividend yield, it seems to be a good time to buy the stock. And when the dividend yield is much lower than the average dividend yield, it seems to be a poor time to buy the stock. Furthermore, it is clear that the dividend yield does not stay at the extreme levels for too long.

These observations form the basis of dividend yield theory, which asserts that the dividend yield of stable dividend-paying stocks tends to revert to the mean.

In essence, a dividend-paying stock is more attractive when it offers a high dividend yield. Investors pile in and the stock price begins to move higher, resulting in declining dividend yield. When the dividend yield deteriorates to a level that no longer attracts investors, buying slows down and the stock price finds a top. With little investor demand (and profit taking), the stock price starts to decline. When the stock price reaches a level where the dividend yield again attracts investors, the cycle repeats itself.

Dividend yield theory is the basis of IQT's long-term investment strategy, as outlined in the 1990 book Dividends Don't Lie: Finding Value in Blue-Chip Stocks, by Geraldine Weiss, and the 2010 sequel Dividends Still Don't Lie: The Truth About Investing in Blue Chip Stocks and Winning in the Stock Market, by Kelley Wright. According to Wright, "dividend-paying stocks fluctuate over time within a range of low dividend yield—establishing a peak of overvalue—and high dividend yield—establishing a valley of undervalue". The peaks and valleys indicate areas where a stock should be bought or sold.

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Disclaimer: I am not a financial professional. Please consult an investment advisor and do your own due diligence prior to investing. Investing involves risk. Ideas presented in this article are the ...

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