While stocks might look risky in the short-term, they offer the highest yield in the long-run, says Prof. Jeremy Siegel, from the University of Pennsylvania, Wharton School of Business. In his book Stocks for the Long-Run, Siegel suggests that the stocks offer more stable real returns than bonds in the long run, thanks to the mean reversion effect:
Remarkable stability of long-term real returns is a characteristic of mean reversion, a property of a variable to offset its short-term fluctuations so as to produce far more stable long-term returns.
Prof. Siegel is also a prominent investor who favors stocks paying substantial dividends. His research shows that the Dow-10 strategy, where one buys the top 10 dividend stocks in the Dow Jones 30 index, can beat the market with lower volatility. One can apply this strategy, or decide to create other valuation metrics. If you go with the second option, that raises the following questions:
Which dividend stock should be in the portfolio? Is there any magic formula to rank dividend stocks for the long-run? The answer is, unfortunately: No. There is no magic formula to make you rich in a short period. However, there are some secrets Wall Street managers use. One of the interesting metrics suggested by Prof. Siegel uses simply three essential parameters:
A rule of thumb for stock valuation that is found on Wall Street is to calculate the sum of the growth rate of a stock's earnings plus its dividend yield and divide by its P-E ratio. The higher the ratio the better, and the famed money manager Peter Lynch recommends investors go for stocks with a ratio of two or higher, avoiding stocks with a ratio of one or less.
Let's explain this further:
- First thing we need is the current dividend yield. The higher, the better.
- Second, we need to estimate the earnings growth. Analysts do this estimation for us -- with a large margin of error. If you are qualified enough to make your own estimation, feel free to do so. For many companies, I have limited information about the future. One reasonable value is the average of past and estimated future five-year EPS growth.
- Third, we need the P/E ratios. Smaller better. Since we are almost at the middle of the 2011, taking the average of trailing, and forward P/E ratios will smooth the results.
Here is the simple, yet powerful, formula, used by Wall Street investors:
T-metrix = (Dividend Yield + EPS Growth) / (P/E Ratio)
I coined the term T-metrix, since the formula above uses only three simple parameters. Applying this formula to U.S.-based, large-cap, dividend-paying stocks with substantial EPS growth history, and positive future expectations gives us the following winners:
Average EPS Growth
Peter Lynch suggests 2 as a perfect number. Therefore, I multiplied the scores by 5 in order to rank the stocks on a 10-point scale. The formula above can be used to rank not only high dividend stocks, but low-dividend or growth stocks as well.
According to the model, one can think of dividend yield as a perfect substitute for growth. As an example, first consider Cisco (CSCO) which has an average P/E ratio of 11.4, and average EPS growth of 10%. Cisco's yield is 1.4%.
T-metrix = (10 + 1.4)/11.4 = 1.
That gives a grade of 5 to Cisco.
Next, consider a high-flier, Amazon (AMZN), which is trading with an average P/E of 60. Average EPS growth of Amazon is 25%.
T-metrix = 25 / 60 = 0.4. Multiply by 5, and Amazon's T-metrix grade will be just 2 out of 10.
Note that the above formula is a simple valuation metrics. Although suggested by a prominent scholar as Wall Street's rule-of-thumb, it ignores many other factors such as dividend growth rate, payout ratio, sustainability, profitability, etc. Yet it can be a powerful tool to add into your knowledge base.