A few months ago I was wondering how I could synthesize the following considerations when buying stock in a company: a) its indicated dividend; b) its price; c) its payout ratio (i.e. how much of the company's earnings does it pay out in dividends); and d) its projected dividend growth. I wanted to buy stock in companies with a high and growing dividend yield but also with high earnings retention. I knew that companies that paid out more than they earned were not promising investments.
So I developed a formula I'm calling sustainable yield. Essentially, it's the dividend yield divided by the payout ratio. Take the indicated annual dividend per share (IAD), divide that by the price, multiply by the last twelve months' net income, and divide by the last twelve months' dividends paid, adding one to that last number so that you avoid dividing by zero. Then multiply by 100.
For a company that pays dividends but only to common shareholders and whose dividend payout is not going to change in the next year, the sustainable yield will approximate the earnings yield (earnings per share divided by price). A company that doesn't pay dividends will have a sustainable yield of zero. A company that pays dividends despite having a negative income will have a sustainable yield below zero. A company that is increasing its dividend gets a higher sustainable yield than a company that is decreasing it. I call this the sustainable yield because it gives low scores to companies whose dividend payments are unsustainable due to their low or negative income or as signified by their shrinking dividends.
"Sustainable yield" is not a concept one normally applies to finance, but instead to "natural capital," especially in the areas of forestry and fishery management. The maximum sustainable yield is the maximum amount that can be harvested without reducing the productivity of the remaining stock. My application of it to the stock market is not really parallel, but the same principle applies: I'm looking for dividend payments that do not harm a company's productivity.
Let's see how this works by using a few companies as examples.
The highest scores are given to undervalued companies whose dividends are growing. A good example is Bed Bath and Beyond (NASDAQ:BBBY), which ranks second out of the S&P 500 in sustainable yield. It has a dividend yield of 1.68%, its indicated annual dividend is 58% higher than the dividend paid over the last year, and it has a price-to-earnings ratio of 7.6. So its sustainable yield is a relatively high 20.37%.
The other ten highest-ranked stocks are:
- Cognizant Technology Solutions Corp. (CTSH)
- Affiliated Managers Group (AMG)
- General Motors Company (GM)
- Gilead Sciences, Inc. (GILD)
- Goodyear Tire & Rubber Co. (GT)
- McKesson Corporation (MCK)
- Corning Inc. (GLW)
- Navient Corp (NAVI)
- Synchrony Financial (SYF)
All of these have sustainable yields between 12 and 20, with the dubious exception of CTSH, which earns the number-one spot (with a sustainable yield of 1,510%) simply because it paid no dividend last year but is paying one this year. Its dividend yield is only 0.9%, so it might be best to ignore this one as a fluke.
Right in the middle of the ranks are companies like General Electric Company (GE), United Parcel Service, Inc. (UPS), and Coach, Inc. (COH), with sustainable yields of 4%. These are reasonably priced companies (p/e's in the mid-twenties) with very little change in dividend payout.
At the very bottom are companies with negative incomes who are planning to pay dividends anyway. Right now, six of the bottom ten are energy companies, two are utilities, and two are pharmaceuticals.
If you were to buy the stocks in each decile of the S&P 500 according to sustainable yield and rebalance monthly since 1999, here's what you'd get:
I've also played around with a slight variation, which has some appeal. Instead of multiplying by net income, multiply by retained earnings, i.e. net income minus dividends paid. This gives companies whose dividend payments exceed their net income a negative score.
Now I don't suggest using this formula as the sole basis for an investment strategy. There are plenty of other things to take into account when choosing which stocks to buy. But it's the best way I could find of taking dividend payments into account.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.