Dividend Yield Theory

Recently, I started a new project for 2019 entitled, the Adopt A Stock Project. The main goal of the project was to adopt one stock every month and add additional funds to that stock. Of course, the interesting problem arose when trying to determine which stock to adopt for the month. At first, I was going to select stocks in alphabetical order, but, some commentators suggested that I have or identify an evaluation system whereby I systematically choose which stock to adopt. A brilliant idea! After all, I work hard for my money, so why not put it to the most effecient use.

One suggestion was to use the Chowder rule. This was a suggestion from JC over at Passive Income Pursuit. JC was willing to help and got me started on the path to learning about the Chowder rule. Although I’m sure it’s a relatively simple metric, I had difficulty with understanding it and trying to incorporate it into my project. But JC said something that reminded me of a metric that allows an investor to quickly evaluate whether a dividend stock is overvalued or undervalued. There might be other names for that method, but one such name is the Dividend Yield Theory. So, I give credit to JC for helping to spark the idea for the approach I will utilize for the adopt a stock project.

Dividend Yield Theory

The Dividend Diplomats wrote an article back in 2014 about the approach I will be utilizing for my new project. That post was entitled Why I Compare Current Dividend Yield To 5 Year Average. It’s a good read, and it’s basically what I will be doing with the Dividend Yield Theory.

Specifically, of all the stocks in my portfolio, I will compare the current dividend yield to the historical 5-year dividend yield average which can be obtained from such websites as Yahoo Finance. I’ve heard about this before, but never really seriously incorporated it in any meaningful way with how I select stocks. After all, I engage in dollar cost averaging and the current price of the stock (and therefore the current yield) doesn’t bother me too much.

After I create a table (hopefully I can make some of the figures automatic), I will purchase the most undervalued stock in that portfolio. I haven’t figured out if I will continue to do that the next month or move on to the next undervalued stock. However, by purchasing additional shares into a stock, I will be adopting that stock for the month.

Prudence suggests that I only adopt the most undervalued stock in my portfolio. But, I haven’t made that determination as of yet.

Visit Simply Safe Dividend’s article on Dividend Yield Theory to learn more about the subject matter.

Understanding Dividend Yield Theory

Another helpful article is the Seeking Alpha article entitled Using Average Dividend Yield For Dividend Growth Stock Valuation by Ferdis.

Ferdis explains that there is an inverse relationship between the stock price and the dividend yield. So, as the stock price increases, the dividend yield decreases and vice versa.

Additionally, Ferdis explains dividend yield theory this way:

” …a dividend-paying stock is more attractive when it offers a high dividend yield. Investors pile in and the stock price begins to move higher, resulting in declining dividend yield. When the dividend yield deteriorates to a level that no longer attracts investors, buying slows down and the stock price finds a top. With little investor demand (and profit taking), the stock price starts to decline. When the stock price reaches a level where the dividend yield again attracts investors, the cycle repeats itself.”

According to the dividend yield theory, as explained by Ferdis, “the dividend yield of stable dividend-paying stocks tends to revert to the mean.”

To that extent, if the current yield is higher than the 5-year average dividend yield, then the stock can be considered to be undervalued. Conversely, if the current yield is lower than the 5-year average dividend yield, then the stock can be considered to be overvalued.

Again, all direct quotes in italics referenced above were taken from Using Average Dividend Yield For Dividend Growth Stock Valuation.

There Can Be Only One

Ok, I might be having a little too much fun with this heading. But, I wanted to make an important point. That is, I recognize that there is no best metric that fits all situations. Quite frankly, the fact that I’m relying on this metric alone as a basis to determine which stock to invest additional funds into should not be construed as a recommendation to do the same by the reader.

I am not a financial adviser, planner, or anything of the sort. And, I think that an investor should rely on more than one metric. But, given the purposes of this project, I do believe that following this approach is much better than choosing the stock alphabetically or at random.

Conclusion

Well, there you have it. I’ve finally found an approach that works for me. Thanks to everyone for your suggestions.

What did you think of this post? Do you agree with the metric I’ve chosen to adopt stocks in my portfolio? Do you think I should only invest additional funds into the most undervalued stock? Or, do you think I should rotate to the next most undervalued stock the following months?

Let me know your thoughts by commenting below.