How To Identify A Quality Company For Investing Using Dividend Yield Theory

The three measures to find quality in the stock market are : performance, performance, performance.

1. Financial performance is the first measure of quality. This includes the company’s record of earnings, dividends, debt-to-equity ratio, dividend payout ratio, book value, and cash flow.
2. Production performance is the second measure of quality. We look for a company that manufactures useful products or services and actively pursues research and development of new products or services. The company must also show an ability to market its products or services successfully.
3. Investment performance, as reflected in long-term capital gains and dividend growth, is the third measure of quality. The most important goal of an investor is a rewarding total return. A well-managed company with a strong financial performance will generate a total return that will outperform any other investment vehicle.

To find this quality, three measures can be used:

  • The dividend has increased five times in the past 12 years. The stocks which have average annual dividend growth of more than 10% over the last 12 years are very good quality stocks.
  • Earnings have improved in at least seven of the last 12 years.
  • The stock has a long history of uninterrupted dividends.( 25 years is ideal, but if you cannot find enough of these stocks, then 20, 15 or 10 years of uninterrupted dividends may be enough)

Some other surrogate measures of quality are:

  • A high quality ranking by the index providers( like S&P 500, BSE). You could say the “A Quality” stocks of S&P 500 or the A group stocks of the BSE are good quality.
  • They should have sufficient liquidity and should be owned by institutional investors.( not absolute, but this means they are relatively safe stocks)

Once you find a quality stock, it is necessary to know if they are of good value. Measures which will help us find this are:

Rule 1. A dividend yield that is historically high for that particular stock, and has repeatedly signaled the bottom of a major declining trend in the price of that stock.
Rule 2. A P/E ratio that is historically low for that particular stock, and is below the multiple for the Dow Jones Industrial Average. The only exception to this rule would be growth stocks with consistent records of rising earnings that are advancing faster than the market average and, therefore, can command higher-than-average P/E ratios.
Rule 3. A strong financial position with a ratio of current assets to current liabilities of at least two to one, and a debt-to-equity ratio of no more than 50 percent debt to equity.
Rule 4. A price that is no higher than one-third above the book value of the company—and the closer to book value, the better. Again, this fourth rule can be broken in the case of companies with proven, superior, long-term growth characteristics

To find undervalued stocks or stock indexes, let us now learn about the Dividend Yield Theory:

According to the dividend yield theory a stock or a stock market index is overvalued when the yield is low and the price is high and undervalued vice versa. The actual yield at which a stock becomes overvalued or undervalued depends on its own history of dividend yield over many years.

The other things to note before investing in a stock or stock market index which you think is undervalued because of relatively high yield and low price is:

  • Whether the market as a whole is high and at the top of its cycle.
  • Any serious fundamental problems with the company that has forced the price to drop down dramatically.
  • High debt or excessively high payout ratio. The dividend payout ratio should be less than 50% for an industrial company and less than 75% for an utility. If the dividend payout ratio is less than 30%, it is likely that the dividend will be increased.

The following figure will make things clear from the value point of view:Value and dividend yield

  • Undervalued: 10% band above and below the point of low price and high yield: Buy
  • Rising trend: More than 10% above the point of low price and high yield: Possible buy if price has not risen too much
  • Overvalued: 10% band above and below the point of high price and low yield: Sell
  • Declining trend: More than 10% below the point of high price and low yield: Possible sell if price has not fallen too much

-notes from the book  Dividends Still Don’t Lie by Kelley Wright

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