The dividend yield theory is one of the most simple, yet strongest tools we investors can take advantage of. Investment services such as Simply Safe Dividends or asset managers such as Investment Quality Trends use this approach to achieve successful investment returns. While the theory at first hand might seem almost too easy, once you read through this post, you will see that it somehow incorporates everything an advanced spreadsheet would do. I recommend that you start using this investment method when you value bluechip stocks.

The Dividend Yield Theory

“The Dividend Yield Theory merely compares a stock’s yield to its historical yield. If a company is mature and the business model relatively stable yield will mean revert and return to a long-term average that approximates fair value

For example, if a dividend aristocrat normally yields 2% and grows cash flow and dividends 10% per year, then buying it at fair value (2%) can get you about 12% long-term total returns (2% yielding + 10% long-term cash flow growth).

If that same company is now yielding 3%, yet the fundamentals are intact, then it’s 33% undervalued (3% -2%/3%) and has 50% upside back to fair value (3%/2%)” – Dividend Sensei

The reason why The Dividend Yield Theory works is that it incorporates all of the functions, debt, earnings, payout ratio, expensive, operating margins and so on, that we use when we normally analyze stocks. What this means is that stock prices are a function on Free Cash Flow and the faster you understand this, the better!

However, The Dividend Yield Theory probably only works for Blue Chips companies that have consistent dividends. I would not recommend using this strategy for any other firms than the Dividend Champions, Aristocrats and Kings.

 

Geraldine Weiss: Dividend Yield Master

Geraldine Weiss’ strategy used the Dividend Yield Theory in her investment and she made fortunes.  However, she as many of us started with Graham and The Intelligent Investor:

“After all my reading, it was Benjamin Graham and his books Security Analysis and The Intelligent Investor that really influenced me more than anything,”

Her strategy was simple:

Buy when the stock is within 10% of its highest historical dividend yield, or the highest for five years, and sell when it is within 10% of its lowest historical dividend yield or the lowest for five years.

The Dividend Yield Master’s 7 Rules

  1. Stock must be undervalued as measured by its dividend yield on a historical basis
  2. It must be a growth stock that has raised dividends at a compound annual rate of at least 10pc over the past 12 years
  3. It must be a stock that sells for two times its book value, or less
  4. It must have a price-to-earnings ratio of 20 or less
  5. It must have a dividend payout ratio of around 50pc to ensure dividend safety plus room for growth
  6. The company’s debt must be 50pc or less of its market value
  7. It must meet a total of six “blue chip” criteria: the dividend must have been raised five times in the past 12 years; have an “A” credit rating from S&P; at least five million shares must be outstanding: it must have at least 80 institutional investors and a total of 25 uninterrupted years of dividend payouts and earnings improvements must have been recorded in at least seven of the past 12 years

How does The Dividend Yield Theory Work?

Since I know you are dying to see a real example of the dividend yield theory, I have chosen two examples:

  • The industrial firm Illinois Tools Works (NYSE: ITW) which I bought based on the dividend yield theory when it trades for $132
  • The mineral company Compass Mineral International (NYSE: CMP) which is a far where you can’t use this theory because the dividend is not stable and the Free Cash Flow is not consistent.

The graph below shows you the 5-year average yield for ITW and the 5-year price-to-earnings ratio. At the end of 2018, the industrial sector took a hit and the stock price went down. Since the stock price and the yield move together but opposite, one could buy this fantastic firm at a yield above 3% when it almost always only yields 2%.

I could not resist this great offer and bought shares for $3500. So far, I am up 23%.

Illinois Tool Works (NYSE: ITW)

Example of the The Dividend Yield Theory

5-year average dividend yield, from Simply Safe Dividends 

 

5-year average P/E ratio, from Simply Safe Dividends 

 

Takeaway from ITW

What you can see from these graphs is that the yield was quite stable at 2% and suddenly it went up to 3% before going down again. This is what we investors often call noise.

Investors often refer to noise as something one should neglect, something that is temporarily and which is more often a buying opportunity than a selling opportunity.

In this case, it was a general bear market in dividend stocks because people looked at the 10-year treasury yield and panicked. Read more about this here

 

Compass Minerals International (NYSE: CMI)

5-year average dividend yield, from Simply Safe Dividends 

5-year average P/E ratio, from Simply Safe Dividends 

 

Takeaway from CMP

As you can see, CMP’s graph is quite different in the way that you cannot really identify any noise. It looks like the yield went up and up from 2014 which is just a sign of a lower stock price.

Hence, the company got cheaper and cheaper in terms of the dividend yield, but as you will see in the next pictures, there was a good reason for the falling stock price.

 

How the Dividend Yield Theory relates to Debt

Earnings Payout Ratio: The percentage of earnings paid out as a dividend. A rising payout ratio means the dividend is growing faster than earnings or that earnings are declining. A volatile payout ratio can indicate a less stable business.

Earnings Payout Ratio, from Simply Safe Dividends 

Net debt to EBITDA tells us how many years a company needs before they could pay off all its debt. Thus, it shows us if the leverage is too high or not, which again could lead to a dividend cut.

 

Net Debt to EBITDA, from Simply Safe Dividends 

Net Debt to Capital tells us how much of the firm’s cash is from debt vs equity. It is common and almost a necessity for firms to have debt, but too much could be dangerous.

Net Debt to Capital, from Simply Safe Dividends 

 

How the Dividend Yield Theory relates to Free Cash Flow

The free cash flow payout ratio tells us the percentage of the free cash flow which the firms pays out as a dividend. The higher free cash flow payout ratio, the larger part of the firms FCF is spent on paying the dividend.

Free Cash Flow payout ratio, from Simply Safe Dividends 

 

How the Dividend Yield Theory relates to Earnings per share

The earnings per share are how much the company earns dividend by the number of shares. “The best businesses will steadily increase their earning power over time to help fuel dividend growth and appreciation in their stock price” – SSD

Earnings per share, from Simply Safe Dividends 

 

How the Dividend Yield Theory relates to Earnings Per Share Growth

The earnings per share growth are similar to the normal EPS, but it tells us if the company is making more or less money. For a rising stock price and a rising dividend, the firm needs to have a growing EPS.

Earnings Per Share Growth, from Simply Safe Dividends 

 

How the Dividend Yield Theory relates to Return on Equity

The Return on Equity (ROE) tells us the profit a company earns for its equity holders. (The difference between ROE and IRR which is used when doing a DCF is that ROE is a period return based calculation (from start to stop), while IRR is a yearly measurement)

Pro tip: A rising or steady ROE is a very very good sign. It is often a sign of a very strong moat.

ROE, from Simply Safe Dividends 

 

How the Dividend Yield Theory relates to Return on Invested Capital

The Return On Invested Capital tells us how much profit the firm has made when you consider both the equity from the shareholders, but also the debt it as taken to achieve this return. What you want to see is a positive double-digit ROIC.

 

ROIC, from Simply Safe Dividends 

 

How the Dividend Yield relates to Operating Margin

The operating margin tells us how much margin, you can read this as safety, a firm operates with. A low margin means that higher costs or expenses might turn the firm less profitable.

Operating Margin, from SimplySafeDividends 

 

Conclusion

The Dividend Yield Theory is a wonderful theory which you can incorporate in your valuation process when valuing blue-chips.

I hope you enjoyed this article and if you haven’t read my article Going Public, you can find it here Going Public and feel free to connect with me here.

Best,

Stockles

 


7 Comments

DivvyDad · March 15, 2019 at 7:13 pm

Nice article and overview on dividend yield theory; I’ve been using this myself for many of my of core holdings and love how Simply Safe Dividends has provided nice tools / analysis to help support that approach.

    Stockles · March 16, 2019 at 10:12 am

    Thanks DD! And agree, SSD is truly amazing 🙂

Bomax · March 16, 2019 at 8:23 pm

Interesting to read, thanks! What about SSD, do you have a paid membership? I would like but it is $399 per year right? What other tools do you use? 🙂

    Stockles · March 16, 2019 at 10:53 pm

    Thanks! I do. I think it’s worth it. It’s easy to make (or avoid losing) 400 USD by using SSD, especially in terms of dividend cuts. I mainly use my own spreadsheets, but finviz is also good among others. Seeking Alpha is always good for ideas but one shouldn’t trust the analysts. I only see it as an idea bank.

Bomax · March 17, 2019 at 8:24 am

And what do you think about the dividend champions list from Justin Law? I use it together with the screener from Peter Gormsen. I’ll think about a SSD membership, thanks. Btw, i like articles from DividendSensei as well from SA.

    Stockles · March 17, 2019 at 2:33 pm

    In general, I think the Dividend Champions is a great list to find stocks with good dividend growth outlook. Dave Fish did an amazing job at compiling this list, and I am happy to see that Peter Gormsen continues Dave’s work. I also like to use Fast Graphs, Valuentum, Dividend.cash, and Gurufocus. However, I don’t think the problem these days is to find information about investments – it’s more about trying to be happy with what you got instead of trying to look everywhere for new opportunities. So easy to start to sell positions in order to get new positions, but then the whole strategy becomes in danger.

- Stockles Blog · March 31, 2019 at 11:24 am

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