Valuing a Dividend Yielding Stock
18 June 2007Having earned degrees in both Engineering and Commerce, I have a penchant for number crunching. As such, once I find a stock that interests me, I like (no, no, need!) to determine a price that is reasonable for that stock. I do not want to just hand over whatever Mr. Market happens to be asking for on any particular day. I want to ensure that I limit my downside and that when I buy from Mr. Market, I am catching him in a depressed mood.
This of course forces me to put a value on a stock. And that value is the highest amount I should be willing to pay Mr. Market for that particular stock. I have currently been using 1 technique to value a stock. But I plan to add 2 more techniques to my analysis.
Dividend Yield
My current method for calculating the value of a stock is to look at the stock’s yield chart. Over the last 10 years, I look at the high and low dividend yield for each year. From this data, I am able to calculate the average high and average low dividend yields for the stock.
The average high dividend yield is a yield that has, on average, been consistently met each year. This implies that I should be able to wait for that average high dividend yield before purchasing any stocks.
To calculate the price that I would be willing to pay for a stock, I simply divide the current annual dividend by the average high dividend yield.
Fairly straight forward calculation and it hopefully will limit my downside as historically, investors have not allowed the price of the stock to drop below the level that yields the average high dividend yield.
I currently calculate the 10 year average high dividend yield. Going forward, I am also going to calculate the 5 year average high dividend yield. This 5 year number will better reflect the most recent history of the stock and the interest rates that prevail in the market at that time.
Graham Number
Benjamin Graham has been hailed as the father of value investing and taught such esteemed investors as Warren Buffett. He had a very simple formula that calculated the highest price a defensive investor should consider paying for a stock. The Graham number is calculated by taking the square root of the product of 22.5 times earnings per share times book value per share. In other words, square root of (22.5 * EPS * BPS).
The purpose of this calculation will be used to gauge how expensive the stock we are looking at is compared to other stocks on my watch list. Of course, the goal would be to purchase stocks at their average high dividend yield and close to their Graham number.
Present Value of Future Stock Price
Another technique used to value a stock is the present value method. This method is a little more involved than calculating the Graham number. The Graham number is calculated from numbers that currently exist. The present value method forces us to determine the price of the stock in the future, and then discount that to a price in today’s dollars so that we can compare it to the current stock price.
In order to calculate the future value of the stock, we need to know 3 things:
- the current earnings per share (EPS)
- the future earnings per share
- the future price to earnings ratio (P/E)
Getting the current earnings per share is easy. It is posted on all financial websites.
Calculating the future earnings per share is more difficult. We have to calculate the rate at which the current EPS will grow at over a certain amount of years. To determine this future EPS growth rate, we have to look at how the company has grown in the past. Hopefully, a trend will exist that will allow us to estimate the future EPS growth rate with some certainty.
To determine the future P/E, we once again look at the historical P/E values that the company has maintained.
Once we have these 3 numbers, we can calculate the future price of the stock. We simply grow the current EPS by our future EPS growth rate. We then multiply that future EPS by the future P/E. That gives us our future stock price.
The last part is to bring that future price back to today. We do that by choosing a discount rate. Over at Investment Jungle, I use a discount rate of 15%. This is the rate prescribed by Phil Town in his book Rule #1.
Like the Graham number, I will use this calculation to gauge how expensive a stock is compared to the other stocks on my watch list.
Value in Dividend Investing
So once I find a solid, dividend yielding company, I will use the three methods listed above to determine a suitable price to pay for the stock. Yield will always be my first and most important determinant of value. If the stock is trading at price which gives the average high dividend yield, then that will still be my main signal.
However, if there are multiple stocks at the average high dividend yield, then finding the stock that is closest to its Graham number or its present value calculation may be the deciding factor.
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on June 25th, 2007 at 8:04 am
[…] How does Average Joe from Dividends Matter pick out stocks? He offers us his techniques in Valuing a Dividend Yielding Stock. […]
on August 28th, 2007 at 3:32 am
[…] The last step of my process is to determine a model price for this stock. I use 3 methods to value a dividend yielding stock […]
on February 3rd, 2008 at 3:55 pm
Hello, this was a very interesting piece and I was hoping I could find out where you came up with your average method. Is it widely known, something you just came up with? I look forward to hearing your response as I am currently doing some work an entire sector analysis using these methods. Thank you.
on February 5th, 2008 at 10:53 am
thanks for the explanations. I was thinking about investing and I find your explanations very helpful
on March 30th, 2008 at 2:56 pm
I too am interested in your average method
on April 4th, 2008 at 4:45 pm
In what text does Graham mention the 22.5? what is the basis for that number? Also, is the number derived from that calculation the entry point or the fair value?
on April 29th, 2008 at 11:04 am
Could you tell me where you find the financial data for the valuations?