- A dividend yield embeds a forecast that assumes constant dividends and zero credit risk.
- Bond investors demand a risk premium on similar promises to pay, promises called "interest" or "principal" instead of "dividend."
- The credit-adjusted dividend ratio bridges the information gap between bond and equity investors.
Traditional analysis of common stocks uses a wide array of financial ratios to measure value. One of the ratios most often discussed is the dividend yield on a stock. In this note we explain why the dividend yield ignores credit risk. We show that a credit-adjusted dividend yield provides much greater insight to the likely dividend return to common stock investors. Using the example of General Electric Company (NYSE:GE), we show that the long-term credit adjusted dividend ratio is 2.94%, not the commonly quoted 3.40%. The credit-adjusted dividend yield allows investors to compare dividend yields on companies of wildly varying credit risk on an apples to apples basis.
Conclusion: A dividend yield is a forecast, not a promise, and investors need to know the probability that the forecast will come true. The bond market provides the information we need to dramatically improve on the traditional dividend yield as a measure of potential return.
Traditional Dividend Yields
Today on SeekingAlpha.com, the key financial ratios for General Electric Company were summarized in this table:
The real time update of the table is readily available to the curious reader. What is the "yield" on General Electric common stock? It is simply four times the quarterly dividend rate on the stock ($0.22) divided by the current stock price ($25.90), or 4x0.22/25.90 which is 3.3977% when carried out to four decimal places. There is nothing wrong with this calculation, but it is a simple calculation that makes a number of implicit assumptions that we know are false:
- That the dividend will not change in perpetuity, continuing as a quarterly payment of $0.22 forever. That is, the dividend will not be increased, decreased or eliminated.
- That General Electric Company will never go bankrupt.
- That no adjustment for the risk of bankruptcy is useful in understanding the risk and return on the common stock.
The dividend yield calculation is mathematically identical to the yield on a consol or perpetual bond. For background on such calculations, see Chapter 4 of Advanced Financial Risk Management.
In the bond market, as we explained in our detailed analysis of the bonds issued by General Electric Capital Corporation yesterday, the idea that an investor should ignore the credit risk of a promise to pay would evoke laughter in trading rooms across the world's financial capitals. We incorporate an evaluation of General Electric Company's forecast (not promise) to pay a dividend using insights from yesterday's bond market analysis.
Credit Spreads and the Value of a Promise to Pay $1
Yesterday's study incorporated General Electric Capital Corporation bond price data as of April 7, 2014. A total of 992 trades were reported on 168 fixed-rate non-call bond issues of General Electric Capital Corporation with a single-day trade volume of $218.9 million. There was also trading in a few bond issues of General Electric Company itself on April 7 but we will use the bond data for General Electric Capital Corporation to save time, recognizing there may be a slight difference. What is the value of a promise by General Electric Company to pay $1 at a future date to a bond investor? Yesterday's study shows that the promise by General Electric Company to pay $1 is worth considerably less than the promise of the U.S. Treasury to pay $1 on the same date. Put differently, to raise a fixed amount of money today in return for a promise to pay $1 later, General Electric Company pays a significant spread above and beyond the yield on a comparable promise by the U.S. Treasury. That premium was documented in this graph derived from the 992 bond trades from April 7:
We are going to use this data to derive the value today of a forecast (explicit, like an announced dividend, or implicit, like the assumption the dividend will be paid in perpetuity) by General Electric Company to pay $1 (or $0.22, or some other amount) at a date in the future. We remind readers that dividends go up, and dividends go down. The General Electric Company website documents nicely that the quarterly dividend payment has dropped from $0.31 paid on April 27, 2009, to $0.10 on July 27, 2009, before rising gradually to its current $0.22 level beginning on January 27, 2014. To keep today's analysis simple, we assume that management intends to pay a dividend of $0.22 each quarter forever unless bankruptcy makes that impossible.
To calculate the present value of the forecast to pay $0.22 each quarter in the future, we need the present value of $1 to be paid on any future date that reflects the credit risk of General Electric Company. The bond market provides a ready source of such data, as yesterday's analysis showed. We recognize that a dividend can be cut (as GE has done) without triggering bankruptcy, so the dividend risk facing common shareholders is higher than the coupon risk facing bond holders. We ignore this difference in risk as a first approximation in calculating a credit-adjusted dividend yield.
We get the present value factors ("zero coupon bond prices") by following these steps:
- Smooth the U.S. Treasury curve as in the weekly Kamakura Corporation interest rate analysis to get the present value factors for a promise to pay by the U.S. Treasury.
- Calculate the risk premium in a promise to pay by General Electric Company (or in this case General Electric Capital Corporation) that minimizes the errors in estimated bond prices using the 168 traded bonds from April 7, 2014.
This chart shows the best fitting "zero coupon bond yields" for General Electric Capital Corporation on April 7, 2014. The accuracy in fitting bond prices was 99.99% (adjusted r-squared of a non-linear regression).
We can calculate the present value factors from these continuously compounded yields using a spreadsheet-friendly formula in Chapter 4 of Advanced Financial Risk Management. This allows us to calculate the present value, over various time horizons, of the "constant dividend forecast" by General Electric Company. We show the first twelve months of that calculation in this table:
The present value of a forecasted payment by General Electric Company of $0.22 in 1 month, 4 months, 7 months and 11 months is $0.8774 (this is the sum of the four present values in the right hand column). The present value of such payments for 10 years ahead is $7.7373 and for 30 years ahead it is $14.7470. This analysis allows a common stock investor to make a "break-even" forecast for the common stock price at the end of each time horizon and compare the value of that break-even forecast with the current $25.90 stock price of General Electric Company.
More importantly, we can ask this question: what constant quarterly amount, if promised by the U.S. Treasury, has the same present value as the $0.8774 one year present value of GE dividends? The answer is $0.219428 (which is the present value of $0.8774 divided by the sum of the four relevant zero coupon bond prices of the U.S. Treasury in the middle column). This figure, $0.2194, is the credit-adjusted dividend payment by General Electric Company. If we multiply by 4 and divide by the $25.90 stock price, we get a 1-year credit-adjusted dividend yield of 3.3888%. This isn't much different from the standard dividend yield, but the difference becomes very large as we extend the time horizon. The credit-adjusted dividend for a 10-year horizon is $0.213347 and for a 30-year horizon it is $0.190521. The 10-year credit-adjusted dividend yield is 3.2949% and the 30-year credit-adjusted dividend yield is 2.9424%, a full 0.46% below the nominal dividend yield. Why does the credit-adjusted dividend yield vary by maturity? For the same reason bond yields vary by maturity: the time value of money and the default risk over that horizon are very important.
The gaps between the nominal dividend yield and the long-term credit adjusted dividend yields can be very large for highly troubled companies. Imagine the gap for Lehman Brothers on September 12, 2008. Equity investors have been ignoring the data used by bond investors to evaluate a similar set of promises to pay, one promise called a dividend and one called interest or principal. The credit-adjusted dividend yield helps to close the information gap between bond investors and common stock investors, and we highly recommend the calculation to serious investors.
Regular readers of these notes are aware that we generally do not list the major news headlines relevant to the firm in question. We believe that other authors on Seeking Alpha, Yahoo, The New York Times, The Financial Times, and the Wall Street Journal do a fine job of this. Our omission of those headlines is intentional. Similarly, to argue that a specific news event is more important than all other news events in the outlook for the firm is something we again believe is inappropriate for this author. Our focus is on current bond prices, credit spreads and default probabilities, key statistics that we feel are critical for both fixed income and equity investors.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Kamakura Corporation has business relationships with a number of organizations mentioned in the article.