Wednesday, June 23, 2010
A core consideration for income investors is an investment's yield, which indicates the value of the payments you'll receive. Yield can be a useful tool in considering whether you'd rather try to generate future income from bonds or stocks, and whether its price is appropriate.
Dividend yield Dividend yield reflects how much of a company's value gets passed on to shareholders. To calculate it, divide the annual dividend by the price for a share of the company's common stock. For example, if a stock offers a $1.75 annual dividend and its share price is $50, its dividend yield would be 3.5%.
A stock's yield also can help you determine whether a stock is undervalued or overvalued relative to its projected income. The dividend discount model uses dividend yield to calculate what the current value of a stock should be based on its anticipated dividends in the future. If dividends are expected to grow rapidly, the present value of a stock should be higher than if dividends are expected to remain relatively static.
Dividend yield only goes so far as a valuation tool. Obviously, a company isn't necessarily worthless just because it may not pay dividends, and the calculation is only as good as the assumptions it's based on. A company can always cut its dividend (just ask shareholders of the nation's banks), in which case the present value of that income stream--and presumably the stock's price--would also drop. A company's growth rate may vary over its life cycle; trying to guess when dividends might change and by how much makes the dividend discount calculation even more challenging.
Bond yields There are many different measures of yield on a bond. Current yield can tell you what your periodic interest payments represent as a percentage of your initial investment. However, for purposes of comparison with other investments, you may also want to consider the value of those interest payments over the life of the bond, including what you could earn by reinvesting those payments at the yield available when you bought it. That's measured by a bond's yield to maturity.
Comparing stock and bond yields
In addition to being a tool for evaluating individual stocks and bonds, yield can be used to assess the relative value of the stock and bond markets as a whole. A method informally known as the Fed model can help you estimate whether stocks are overvalued or undervalued relative to bonds. (However, the so-called Fed model is not officially endorsed by the Federal Reserve.)
Though there are variations on the method, the original model compares the yield on the 10-year Treasury note to the forward-earnings yield per share of the S&P 500. Earnings yield is calculated in much the same way as dividend yield is: by dividing the per-share earnings forecast (rather than the anticipated dividend) for the next 12 months by the current share price. If the result is lower than the yield to maturity on a 10-year Treasury note, stocks might be overpriced. Why? Because the Treasury note offers a higher yield that involves less risk. On the other hand, if the forward-earnings yield on stocks is higher, then you're at least being compensated for the higher risk involved with stocks.
However, for the average investor, the model also has flaws. If earnings prove weaker than predicted, actual stock yield might not be as high, which would throw off the comparison. Also, using trailing earnings over the previous 12 months rather than forward earnings as your yardstick would give you a different result. Dramatic swings in Treasury prices can make stocks seem less expensive than they might be when compared to their historical performance. And even if equities or bonds appear cheap, there's no guarantee either one won't be an even better bargain in the future.
In addition to being a tool for evaluating individual stocks and bonds, yield can be used to assess the relative value of the stock and bond markets as a whole.
Yield shouldn't be the only factor in your decision, but it can help you compare apples and oranges.