ADDENDUM:YDP Analysis Tutorial & Comparison With Traditional Valuation Techniques For Dividend Income Equities
If you are an income investor, there are many different classes of investments available to you, including such things as rental properties, equipment leasing, bonds, stocks, annuities, and other more exotic instruments, even active businesses such as a store or manufacturing plant. Each class has its unique features that may make it more or less attractive to your own goals and desires. All of these classes (and the individual choices within each) share a common thread. Their sole ultimate purpose is to generate income for you as a return on your capital. To some extent then, ideally, each is a black box you put capital into and income comes out the other end.
Fundamental value analysis looks at several key business statistics using both historical data for them and making forward-looking predictions of what those statistics will be in the coming year(s). By comparing the past history and the future predictions within a company's data set and against its peers, a value is then determined. Although it is often referred to as fundamental valuation, it is really relativistic value, since it is comparative by its nature. Thus, the weaknesses are 3-fold; 1) reliance upon historical data that was subject to management manipulation by bookkeeping techniques and the timing of expenses and revenues, 2) misjudgment in the forward assumptions and predictions, 3) the relativistic nature that concludes value today is arrived at by comparing today's key metric statistics and appraising a price based on if these metrics match, exceed, or lag the internal history and that of peers.
Another popular valuation method you see touted is Net Present Value [NPV], usually adjusted by discount rate for the time value of when future income is expected and risk. The NPV Return On Investment (NPVROI) relies on an accurate prediction of the future income stream, the timing of that income stream (along with any capital infusions needed to generate the stream), and the discount rate (inflation rate and cost of funds) to convert it all to net present value. This NPVROI model, which is touted as more reliable and scientific than fundamental metrics, is really a lot of risky guesswork, as you can see.
YDP analysis does not need nor use any forward-looking projections, assumptions, nor estimates to arrive at an appraisal of fair value. Instead, it only uses historical data to do the job, Yield rate [Y] , Dividend Distribution [D], and share Price [P]. The technique is, of course, limited to investments that pay a dividend (or like a kind of regular periodic distribution) and trade on an active and open market, where the bidding up and down of price based on buyer/seller demand is liquid enough to allow those market forces free rein. In such cases, the mathematical formula Y=D/P likes these 3 variables. The company management sets the Distribution, the market place of investors sets the share Price by free market auction forces, and the Yield is the mathematical ratio of the two. Nothing further is needed. However, a look at the historical and current reliability of that distribution stream is useful in assessing the risk of it maintaining a trend going forward. For this reason, I incorporate a trendline and current payout ratio view to assess risk to the distribution. This risk can further be reduced by focusing on companies with a long history of steady or steadily increasing distributions over a period of many years. The Dividend Aristocrats are an example of a group of such companies.
All widely traded investments have a multitude of attributes, which each attract a particular individual. One may look for tax-efficiency, another for tax deferral, yet another for tax avoidance. Others may look for growth, have an attraction or affiliation to the industry, like the color of the annual report, or any of 100s of other reasons for buying and selling a given share. Thus, there is a lot of "noise" in the Y=D/P market pit that is generated by buy/sell demand not purely tied to income yield. For this reason, YDP analysis in general, and my use of it in particular, tries to focus only on tickers that are widely followed by income investors.
YDP pattern analysis can actually be used to determine if a stock is strongly influenced by things other than income yield or if outside factors are only weak forces on the YDP driven market balancing. A steady distribution with widely fluctuating price (and therefore, also the inversely correlated yield) even within a given market cycle is a clear sign that something other than income is the main force driving investors in the market for those shares. Therefore, the YDP chart patterns even help tell you whether you are looking at an dividend income driven equity or if it is more valued for something else (such as growth, cycle hedging, or other factors which may or may not be apparent from the pattern and its relation to macro economic cycles).
YDP analysis rises to its greatest usefulness and reveals the most valuable and nuanced interpretations when used in conjunction with other techniques, such as fundamental metrics and NPVROI. A careful study of pattern trends and their relationship to the macro and micro economic environment they have occurred in will reveal otherwise hidden information that is not available from any single technique alone. Nonetheless, YDP valuation itself is sufficient for fair price appraisal for most dividend income equities. I hope you will find it a useful tool and follow my use of it in ferreting out opportunities for quality income, along with my application of covered option writing to further boost that income and lower market risk. You will find my work published on SeekingAlpha.com.