Dividend Yield
Dividend yield is calculated by dividing the annual dividend per
share by the price per share or the annual dividend by the market cap. A
high dividend yield could reflect stocks that are undervalued and will
provide a higher return. To determine if a dividend yield is high, it is
often compared to the market yield. For example, the average dividend
yield for the S&P 500 over the the last six decades leading up to
2013 is 3.4%. Using this as a benchmark, any yield above this mark is
attractive. Rising dividend yield can be the result of two occurrences: a
falling stock price or a rising dividend payout, the latter being
preferable. Another use of dividend yield is to compare it to the yield
on 10-year treasuries. If an investment’s dividend yield is greater than
the treasury yield, then that investment is attractive given that the
risk profile is not too high.
Earnings Yield
Earnings yield is the last 12 months of earnings per share divided by
the current price per share. The earnings yield measures how much
return an investment in a company earned over the past 12 months.
Earnings yield is the inverse of the popular price/earnings ratio. Like
the dividend yield, the higher the earning yields, the more attractive
the investment. Earnings yield is extremely useful for comparing various
markets. For example, if the current 10-year treasury yield is 3.5% and
the earnings yield for S&P 500 is 5%, then the stock market is
undervalued on an earnings basis compared to the bond market. Company
shares trading at an earnings yield greater than 5% will be considered
undervalued compared to the market. The criticism of using the earnings
yield, like the P/E ratio, is that earnings are easily manipulated. And
because of the potential for creative accounting to impact earnings,
some investors prefer to use free cash flow as a truer measure.
Free Cash Flow Yield
Free Cash Flow (FCF) yield is the annualized FCF per share divided by
the current share price. FCF yield is popular with investors who
believe the true measure of a company’s operating strength is sought by
following the cash. FCF is the cash left over after paying all the
operating expenses and capital expenditures, or operating cash flow
minus capital expenditures. Determining how much cash a company
generated, after paying its operating expenses and other ongoing costs
to keep itself operating, and comparing that to the price per share
provides the company’s true value. The higher the FCF yield, the more
attractive the investment. The FCF yield points to the fact that
investors would like to pay as little as possible for as much earnings
as possible. Similar to earnings yield, the FCF yield can be used to
compare companies across the same or different industries.
Which ‘Yield’ Makes Sense?
Are there advantages to using one yield measure over another? That
depends on the investor. No one measure is the “holy grail.” Each has
its critics and proponents. Dividend yield is perhaps the most
frequently used yield measure. It is also the one that is left to the
company’s discretion, because dividends can be increased, decreased or
suspended by the company at any time, although companies try not to
reduce dividends because it is a negative signal. Therefore, dividend
yield is not the best yield measure when looking to value a company, but
it can indicate a company’s general trajectory.
Investors will often compare dividend yield to the yield on 10- year
treasuries (a riskless asset) as a proxy for stock market
attractiveness. Secondly, the yield level or percentage change can give
investors foresight into company management’s expectations of future
cash flows and growth prospects. Lastly, dividend yield can be used in
conjunction with other measures. For example, FCF provides insight into
the cash generated after expenses. If the FCF is low and the dividend
yield is high, this indicates a mismatch in the investment’s valuation
using both metrics and should raise a red flag for the analyst or
investor. In contrast, if the FCF is high and the dividend yield is low,
the company could be signaling a future acquisition or other growth
investment that could be a positive catalyst for the stock.
FCF yield and earnings yield are two measures that can be used to
value a company and compare it to other investments over time. These
yields look at valuation in two ways, the former using cash flow and the
latter using earnings. Although proponents and critics argue about
which measure is a better indicator of “true earnings,” both can be used
to find strong companies. Take the following example:
In this example, Stock B has a higher earnings and FCF yield than A,
which says that the stock appears undervalued on both measures. Also,
one can notice that the earnings yield has a larger spread than the FCF
yield, which should make the investor look deeper into the financials to
see where the cash is going or what makes the company’s earnings much
higher.
In another example:
In another example:
In this example, Stock B has a higher earnings yield but a lower FCF
yield, which can lead to two conclusions. The first is that earnings are
being propped up by non-cash items like depreciation. The second
conclusion is that FCF is being reduced by large capital expenditures.
Using the two yields in conjunction with each other provides a
clearer picture of the company’s valuation than either measure alone.
Although earnings and FCF yields look backward, using these measures
together with dividend yield may provide some forward-looking insight
into the management’s expectations of future earnings.
The Bottom Line
Dividend, earnings and FCF yields are applicable measures on their
own, although their limitations are noteworthy. Understanding the inputs
that go into each calculation better prepares the investor for the
measure’s usefulness. But used together, these yield measures can paint a
clear picture of a strong or weak potential investment.
Source: leinvest
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