Dividends are a wonderful thing, allowing investors to use the money to pay for daily living expenses, or to put that money back through working through reinvestment. However, dividends are a big gain for investors. But there’s more to a dividend than just this, because you can use a company’s dividend yield to guide your investment approach. Here are three tips for dividends, based on that core foundation, that can earn you thousands.
First some background
Valuation is important in the investing world. Paying too much for even a great company and it can very quickly turn into a bad investment. That is one of the core values of value investing. The case of extreme value is buying what some companies have called for cigar button, which are down and out, but so cheap that there is still some value to be had. That is not the right approach for most investors. The better option, especially for conservative species, is to find companies that are doing well and wait until they trade at an attractive price – a tactic laid down in the iconic book The intelligent investors by Benjamin Graham, the man who helped train Warren Buffett.
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Often, investors are told to make long-term projections for cashstream to arrive at the true underlying value of a company. Buy below that price, with maybe a little pillow added for safety, and you can be pretty confident that you are getting a good deal. That’s a great idea, but it’s a lot of guesswork (no one on Wall Street has a crystal ball) and a lot of time and effort. It is impractical for more than a few supplies at a time. A shortcut is to simply focus on ratio analysis, using tools such as the price-to-ratio ratio. This allows you to look at many companies in a short period of time so that you can concentrate on the names that pass through your first rating screen.
But if you love dividends, there is another option that will sit right in your wheelhouse: dividend yield. Dividend yields go up and down as the price of a stock rises and falls with time. In general, the return will be high where investors, as a group, think it is reasonable compared to the risks and potential of the company supporting the payment. In other words, just like P / E, you can use your dividend yield as a valuation tool. That’s the core of this very valuable tip, but there’s more to the story than just that.
1. Yield relative to the market
The first thing you want to consider as a dividend investor is the return you can get relative to the broader stock market, with a comparison like the S&P 500 index. This provides a measure for thinking about dividends in general. If the yield on the S&P 500 is about 1.8%, as it is today, then a company with a yield of 3% actually offers a pretty generous dividend compared to the market. It may be worth a closer look, even if your ideal goal is higher. But the spread between the two yields is even more telling, with a larger difference indicating a name that is not in favor.
MMM Dividend Yield data by YCharts
Industrial giant 3M (NYSE: MMM) is now an excellent example. As the chart above shows, the spread between the yield of 3M and that of the S&P 500 index SPDR S&P 500 ETF as proxy is really extended. Investors are clearly downbeat on 3M, and that may be worth a closer look. You can still use this tip for stocks that typically have low returns, but you will be looking for the spread between the stock’s returns and those of the S&P 500 index.
2. Yield relative to peers
That said, entire sectors often go in and out of advantage together. So you will also want to look at a company relative to the sector in which it operates. In the case of 3M, that is the industrial sector, and use Vanguard Industrials ETF as a proxy you can see here that the company also looks attractive.
MMM Dividend Yield data by YCharts
Indeed, as the diagram above shows, the yield of 3M is also high relative to the wider industrial space. This is a great image view, which in many cases can be more than enough. However, you can also attract some of the direct peers of the company. For example, industrial giants Honeywell en Emerson Electric both have remarkably lower yields than 3M. Thus, 3M still looks relatively attractive yield wise.
Revenue relative to the company’s own history
This raises one last issue – how does the current return compare to the historical trends for the company you are researching? For example, a 3% return for a company that has long yielded 6% may not present a great long-term buying opportunity for value-conscious investors. But that same return for a company with a history of offering, say, a return of 2% is a different story.
MMM Dividend Yield data by YCharts
As this chart shows, the current yield of 3M is towards the high end of its historical range. In fact, the last time this was so high was during the recession of 2007 to 2009. Remarkably, the US fell into a recession in February, so that makes quite a bit of sense. The important takeaway, however, is that 3M looks cheap compared to its own revenue history today.
More work to do
Do not run out at this point and buy 3M. What you have done is identify it as an interesting candidate for investment because of its generous returns relative to the market, its peers and its own history. You need to know the business a little more before you pull the trigger. But with one simple tool, and three tips based on variations of the same theme, you soon found out that a deep dive is probably worth the extra effort. And at the same time, you have proven that the dividend yield of a business can be a powerful investment tool if you know how to use it.
