This is a guest post by Brett Nelson of Simplifying Finance, a guide for people who want to take control of their finances with saving and DIY investing techniques.
As a value investor, I'm always on the lookout for companies trading below their intrinsic value. You might be wondering how this is possible.
A lot of people think the price they are seeing is the value of a company. Well, I'm here to tell you that price and value are very different!
So, what's the difference?
Well, price is determined by the number of people who are actively buying a stock at any given moment. Therefore, price can be heavily affected by events like good and bad news. These types of events usually only have a short-term impact. Therefore, they have little impact on a company for the long term.
The intrinsic value of a company, then, is what it is actually worth. As a value investor, I only want to purchase companies whose price has dipped below their intrinsic value.
Preferably, I find companies that are trading well below that intrinsic value. The difference between the price and intrinsic value in this scenario is called the margin of safety.
The greater the margin of safety, the less risky your investment will be. Not only that, but the greater the margin of safety, the more room you leave for higher returns. Therefore, value investing inherently gives you lower risk with a chance for higher return.
Dividend Yield and Intrinsic Value
Another great thing about value investing is it automatically gives you higher dividend yields. One thing I've found with stocks is that investing in companies with a dividend yield of 3% or higher is usually a good thing. Now, this is a personal rule and does have some flexibility.
The important thing here is to realize that a dividend yield of 3% often means the company is close to its intrinsic value. 3% is good and all, but there is also the opportunity to achieve much higher yields.
If you're engaging in value investing, you're going to see high dividend yields. High dividend yields are typically around the 5-6% range I've found. An automatic 5-6% return is an amazing thing, and should always be taken advantage of.
The reason why value stocks may have a higher yield is because of the difference between price and value. If a company has encountered an event that has caused it to trade lower than its intrinsic value, it is a value stock. The best part about this is that the drop in price means a much higher yield.
For instance, pretend that a company pays out 75 cents per share per quarter for its dividend. If the company is trading at $100 per share, that's a 3% yield. Not bad. However, if you are a value investor and you calculate the company's intrinsic value to be $100, you may hesitate to buy.
Then, imagine you found the same company and calculated the same intrinsic value. However, this time, it is trading at $60 per share. You examine the financial statements and determine that there are no major warning signs. In addition, that 3% yield has become a 5% yield!
Not only does measuring intrinsic value provide lower risk with potentially higher returns, but it also can provide higher dividend yields!
How Dividend Yield Can Help You Value the Market
There is also an inverse relationship between dividend yield and value investing. We already saw how buying value stocks can help you find high yield stocks. But what a lot of people don’t know is that dividend yield can also help you value the market!
We talked earlier about how dividend yield will rise as prices go down. Therefore, it's possible to get a rough estimate of whether the stock market is overvalued or not. Take the S&P 500, for instance. If its yield is in the 1-2% range, it's probably overvalued. In contrast, if the yield is over 3%, it might be a good time to start looking into it some more.
The yield for the S&P 500 is currently hovering around 2%. This backs up the popular sentiment right now that the market is at least slightly overvalued. As a value investor, I become wary during these warning signs.
It is important to remember that dividend yield is only one indicator of an overvalued market. There are other metrics that are important as well. However, dividend yield does provide some insight at a glance.
Payout Ratio and Dividend Traps
Like with anything, there are also things to watch out for with dividend stocks that have a high yield. You want to make sure you don't fall into a dividend trap. Traps will entice you with high yields and low prices, but might actually be a bad investment. To avoid this, you have to make sure you do your research.
With high dividend stocks, I'm always skeptical of the payout ratio. Extremely high payout ratios are unsustainable for a company to maintain. Therefore, the dividend yield would be unsustainable. In this situation, the dividend yield would be reduced as dividend payments were cut. A huge problem with this is that the stock price usually plummets as well when this happens.
This is why payout ratio is so important. If a payout ratio is over 40, you should start to be worried. If it is over 60, this is unsustainable and you should stay away. Generally, the lower the payout ratio, the better. The payout ratio is one of the ranking factors in "The 8 Rules of Dividend Investing."
This is the type of trap I see all the time as a value investor. Because I look for stocks trading below their value, I often look at stocks that have had drastic price drops. One of the most critical aspects of value investing is the research into why this price dropped. This requires qualitative research as much as quantitative, and many people skip it. However, if you don’t do your due diligence, you will get burned eventually.