Dividend Yield As An Indicator Of A Bargain

Includes: GD, IBM, LMT, ROST, RTN
by: Canadian Dividend Growth Investor

We all want to pick up a good company at a lower price so we can start off with a higher yield. But, how high must the yield go to indicate the possibility of a bargain?

Step 1: On Seeking Alpha, create a portfolio of stocks you're following. If the current yield is significantly higher than the 5-year average yield, there might be an opportunity. If the prices of the stocks of a general sector have been compressed so that their current yields are significantly higher than the 5-year average yield, then that might mean there isn't a company-specific issue. In that case, you just need to determine which is the best to buy.

Step 2: Go to ycharts.com. Look at the dividend yield graph of the relevant company. Look at the tops and compare it with the current yield.

If you're at a top, you may have found a bargain. But don't be hasty, make sure to do a fundamental analysis on the company, such as checking its valuation, earnings, debt levels, and dividend growth history. Here is an example of doing a quick fundamental analysis on Ross Stores. This check of comparing a company's dividend yield with historical yields is just one quick way to sift through your watchlist of dividend growth companies.

I actually divide my watchlists into their respective categories, such as Aerospace & Defense. This allows me to easily scan and compare their dividend yields with their 5-year average dividend yields to determine whether the difference is big enough or not. For instance, I have an Aerospace & Defense watch list including Lockheed Martin (NYSE:LMT), General Dynamics (NYSE:GD) and Raytheon (NYSE:RTN) as follows:

Seen above, the current yields for these companies are higher than their 5-year average. So, we continue onto Step 2. For instance, for Raytheon, I see that in the past 5 years, there have been multiple times that its yield got almost to 4%, so a long-term investor might try to grab some Raytheon shares closer to the 4% yield if he or she decided he or she wanted to own part of that company.

Raytheon: 5-year Dividend Yield Graph

By the way, this strategy of finding possible bargains doesn't work well for companies that have higher earnings growth, with lower yields, higher dividend growth, and whose prices follow their earnings closely. International Business Machines (NYSE:IBM), and Ross Stores (NASDAQ:ROST) are such companies. What happened in their case is that their dividends grow as fast as the price appreciates, so that the starting yield stays in a defined range most of the time.

Ross Stores: 5-Year Dividend Yield Graph

International Business Machines: 5-Year Dividend Yield Graph

So buying such companies at fair value is not a bad idea, but it would be a more attractive opportunity if you can grab them at undervaluation. For Ross Stores, an interested investor might want to grab it above the 1.1% yield. For IBM, a long-term investor might want to grab it around the 1.8% yield area. By the way, if you purchased the company in last week's dip, you would be grabbing IBM shares at above the 1.8% yield, as it is expected that it will raise its dividends in May.

Graphs from ycharts.com

Disclosure: I am long IBM, ROST, RTN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.