With the market almost completely focused on dividend yields, it's clearly time for the average investor to step back and understand what makes up a dividend. In essence, it is the portion of retained earnings that a company wishes to pay to shareholders. All dividend payers decide whether to pay 10% or 100% of earnings or typically somewhere below 50%.
Is that really the metric an investor should use to determine the best value in the stock market or even between different asset classes? In a way, this is the lazy man's metric. The key is that dividend yields are the amount that the company decides to pay. How did such an arbitrary number become a focus of modern investments?
A company paying a 5% dividend might have a payout ratio of 70%, while a company paying a 4% dividend has a payout ratio of only 20%. Which company is a better stock to buy?
Now is the time for investors to become more educated about dividends. In a recent article, Stone Fox Capital focused on the Net Payout Yield which is the combination of net buybacks and dividends. This method focuses on the total payout to shareholders from a corporation and doesn't place an emphasis on one option alone.
Another method that isn't used often is the Earnings Yield. In reality, when an investor buys a stock he is buying the future cash flow potential of a company and earnings yield is one way to measure at least the current valuation to income. When deciding between alternative investment classes, one way to decide between stocks and bonds is the earnings yield of the stock in question or the market in general.
Though the earnings yield tells an investor what the company is making compared to valuation, it unfortunately won't derive the stock price over at least the short term. Of course, neither will the dividend yield.
In normal times, investors are willing to receive a lower yield for stocks compared to bonds due to the ability of stocks to grow earnings over time. Currently though, the earnings yield of many top stocks has gotten to the point of easily surpassing the 10-year Treasury Yield by multiples.
Figure - Select Stocks Earnings Yield Versus the 10 Yr Treasury
Unfortunately the chart above uses a different scale for the 10 year Treasury, but readers should get the point of the dramatic shift in the yields over the last 5 years. Anybody buying Aetna stock gets a stock earning nearly 12% of its currently valuation compared to 1.65% for the 10 year. On top of that, the stock will undoubtedly earn at higher levels over the next 10 years while the Treasury won't budge if you buy it now. The end result should be a much higher return for investors in the above stocks.
Additional disclosure: Please consult your financial advisor before making any investment decisions.