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The Dividend Yield of a stock is an important metric to use when evaluating which stock to buy. Many people use it in conjunction with other valuation metrics such as P/E (Price to Earnings) or P/S (Price to Sales). However, when purchasing stocks to add to a dividend growth based portfolio, the current yield acts as more than just a purchasing indicator. It is perfect for determining both the entrance price and the exit price when the time comes.

Let me explain myself. To many Dividend Growth Investors on this site, it is sacrilege to sell a good company, and for good reason. Their reasoning is that nobody can possibly time every market pivot point, and therefore shouldn't try to. This has an enormously useful impact on the skittish investor(unknowing trader/speculator), who otherwise would declare that they are not getting enough return from their inventory of stock and sell it, looking for the "perfect investment."

I am here to tell you that there is no substitute for rigorous research. Find the right company, become part owner with that company, and stick with it. That was for the skittish "investor." What comes next is for those of you with guts.

The Strategy

The Dividend Growth strategy is phenomenal, in my opinion. Many thanks to authors such as David Fish, David Crosetti, David van Knapp, Robert Allan Schwartz, and many others for writing so extensively on this topic. I hope to add something to the conversation.

As per Dividend Growth Investing, it is customary to find multiple companies with a) a track record of increasing dividend payouts b) solid fundamentals c) and a sustainable payout ratio to continue increasing dividends. If you are relatively new, Seeking Alpha author David Fish keeps updated lists on which companies have increased their dividend payouts for 5, 10, or 25 years. (CCC lists). Fundamentals are the result from substantial research. Payout ratio information is available on Yahoo Finance or Ycharts. The idea is to initially remove current yield from the equation to end up with a pool of great companies to choose from. Keep this list maintained, as you will no doubt require more companies in future to invest future funds into. When it comes time to actually invest the money, we need to choose the one that not only meets all the above criteria, but also be looking at the ones with the current highest yield.

Say that you purchase a $100 stock that currently yields 4%. The $4 that you receive will increase year over year as the company becomes more profitable. This is the controlled variable in this equation. While the dividend remains constant, and actually grows, the stock price will gyrate due to the movements of the markets. However, instead of saying that it is overvalued when it reaches an arbitrary number, we set a minimum yield at which we would like to own the stock. Now, say that the stock keeps up the $4 payment, but the yield falls to 2.5% or 3%? The stock price that corresponds to that yield would be $160 or $133, respectively. I'd say that is a generous capital appreciation. However, if it never happens, enjoy the 4% dividend payments until it does!

An interesting point to make about this strategy is that the desired exit price will always be increasing. This is because of the increasing dividend and subsequent adjustment in the yield calculation (The price must increase to maintain the same yield percentage). This will make the exit price increase every year, while you get the benefit of the increasing dividends.

The next stage of this strategy is simply the redeployment of the capital (plus its newly realized gains) into a new investment that will yield 4% on the new amount. 4% of $133 is a new income of $5.32, instead of $4. The mantra of the Dividend Growth Investor is important. The idea that they do not take active notice of the gyrations of the market, and instead focus on getting an increasing stream of income allows for this small tweak to the strategy. DGIs will still be perfectly content to hold an undervalued stock paying that increasing dividend even if it does not get any capital appreciation. However, when capital appreciation does occur in this type of portfolio, it is imperative to take advantage of those capital gains in order to increase the income received from the portfolio.

There is a valid counterargument to this approach which is that there is not always a new investment to place the money that meets this strategy. Let me say that if there is no new place to deploy the money, keep it there. It is better to keep the capital in that overvalued company working, than to hold it in cash. The reasoning for this strategy is that each stock is different. While one stock may be overvalued in relation to its underlying assets, another will generally be undervalued for its assets. This strategy is meant to be used when both sides are represented. If both sides don't exist then don't worry about it, and definitely don't stretch a non-qualifying stock to be used here. Stick with the reliable companies.

An Example

I have always liked the Coca-Cola Company (NYSE:KO). It has sound fundamentals, a rock star balance sheet, and is expanding deeper into other (emerging) countries. While this is all true, sometimes the market sees it, and prices it accordingly (and then some).

(click to enlarge)KO Chart

KO data by YCharts

Coca-Cola stock for the long run is a fantastic investment. However, there are times in its history that the yield had gyrated considerably. The dividend has always gone up, but because the market decided so, in 2004, it yielded less than 2% and in 2010 it yielded a little over 3.5%. Now Coca-Cola looks moderately valued. In the event of a pullback, the shares could yield well north of 3%. However, there are other fish in the sea, and they are hovering near the net!

Show Me The Money

(click to enlarge)PG Chart

PG data by YCharts

For Proctor & Gamble (NYSE:PG), it would appear that although the dividend increased at a constant clip up to now, before 2008, the stock increased much more quickly than said dividend. After 2008, on the other hand, had seen the continued dividend increases, but less price increases, which resulted in an attractive yield. Although in the course of doing research another dividend growth company might stand out as a better investment, this stock is still quite attractive, and also serves as a starting point for that research.

Conclusion

Using the Dividend Yield as a major variable in the purchase and sale of a stock is useful for all dividend stocks. However, it is even more effective when used in the analysis of Dividend Growth stocks because the dividend is reliable and increasing, which results in a measurement of the stock price relative to the dividend the investor expects to receive. This metric can be used to objectively define stocks in occasions when P/E (although still remarkably useful) will require a substantial amount of subjectivity to bridge the gap in congruency (such as different industries or sectors).

Source: Dividend Yield's Importance As A Valuation Metric