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Subject 8. Dividend Yield PDF Download
Total return has a capital appreciation component and a dividend yield component. Dividend yield (D/P) is a measure of return that does not account for capital appreciation but can be used for relative valuation purposes.D0 / P0 = (r - g) / (1 + g) 
Unlike other multiples, dividend yield has price per share in the denominator. The numerator depends on the purpose of the analysis.
- Trailing D/P = (4 x last quarter's dividend per share) / market price per share.
- Leading D/P = next 4 quarters' forecasted dividends / market price per share.
Advantages:
- Dividend yield is usually a more predictable and less risky component of total return than capital appreciation.
Disadvantages:
- It ignores capital appreciation.
- Trade-off: current versus future cash flows. Dividends paid now reduce future earnings by reducing reinvested income and therefore choice of higher dividends today also implies lower growth in future.
- The argument that dividends are more stable than capital gains contradicts the EMH and is still to be proved empirically.
Valuation Based on Forecasted Fundamentals
From the Gordon DCF model we can get a fundamentals-based formula for the justified dividend yield:
From here, the dividend yield is positively related to the required rate of return and negatively related to growth.
Valuation Using Comparables
The same approach applied to other multiples holds for the dividend yield as well.
Example
SW Utilities is preferred: same risk, higher total expected return.
User Contributed Comments 7
| User | Comment |
|---|---|
| americade | Does it occur to anybody that the Do/Po justified is the inverse of the Price/CFo??? |
| katybo | thats right according to the formulas |
| katybo | ...but growth is not equal! |
| duoluo | growth rate of cash flows vs growth rate of dividends |
| wink26 | I have a problem with the logic behind this section, and I always have. Companies that don't pay dividends MAY reinvest that money to earn a high rate of return, but as the no-dividend company policy is extended and the firm suffers diminishing returns (or perhaps outright losses) you never see any of those higher earnings. The company's profits just feed R/D or expansion until they make a bad bet, or over-expand and lose it. Doesn't make for a logical textbook answer, but I think it's quite common in the real world. This is probably most typical when the Board Chairman is also the CEO, or there isn't significant separation b/w the board and the company. |
| SageofOmaha | It is totally wrong to grow just for growth's sake.If a company cannot effectively invest earnings above the rate of return generally available for investors, then the company should pay out its earnings in the form of dividends.This is the essence of capital allocation. |
| davidt876 | ^ I actually think most companies are reasonably good at distributing (dividends or buybacks) when they're mature and their growth outlook is dimming down - or maybe shareholders are good at strong arming them into it. and sure companies screw up and make bad investments, but I'm confident wink does too. it's a part of it. and so i think its a matter of risk appetite and trust in the market and company. by imposing a dividend policy on management ur effectively saying you don't trust them... and why invest in the first place if you dont trust management to invest on your behalf, or distribute when they can't? if you really feel that way then get into fixed income and demand your 5% every year. but guaranteed income is really not the point of equity |
Your review questions and global ranking system were so helpful.
Lina
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