on dividends’’from buying partial shares every quarter, those increased holdingsalso offer the potential for capital gains in the future. The moredividends reinvested, the more you earn and the more additionalshares you receive.3. A company’s ability to pay and increase dividends is a criticaltest of sound management. As one important test of a company’sability to manage its cash, the history of dividend payments is logical. A company needs cash in order to pay dividends. You will discover that a consistent history of dividend payments goes hand inhand with long-term growth in the company’s value and in the market value of its stock. The ability to pay dividends also depends ona company keeping its long-term debt under control. As more debtgoes on the books, a growing amount of available cash ﬂow hasto be paid in interest to bondholders and other lenders, as well asrepayments of principal. The higher the debt service, the less cashremains for dividends.4. Checking and comparing dividends is a great way to narrowa list of potential investments. Some investors pick a short list offundamental and technical criteria for stock selection. Even so, they
49
Yield and Yield History
may end up with 20 or 30 companies they like. Most investors, forpractical reasons, will do better narrowing their list to 10 or fewercompanies. Checking the history of dividend payments and the current yield will help to pare down the list.Investors tend to set goals for themselves. For example, theymay decide to sell a stock if and when it gains 20 percent in valueor doubles; they may also sell if and when the stock falls 10 percentor does not move at all. While many of these initial goals will beviolated later based on changing conditions and perceptions, theyare set on some basis.It is a mistake to leave dividends out of this equation. For example, if you would like to experience a 10 percent appreciation peryear, that is a difﬁcult goal to reach. With the volatility in the market, few stocks have achieved consistent growth with reliability.Those that do rise 10 percent per year may also fall as much ormore. Volatility equals risk. So as a consequence, it is often necessary to lower your goal somewhat. However, when you add dividends into the equation, goals are more easily reached. Forexample, if you would like to have annual appreciation of 10 percenton your original investment and a stock is paying a 3 percent dividend, you accomplish 30 percent of your goal just by purchasingthe stock. Now you will reach your goal if the stock appreciates by10 percent. And the fact that dividends can be reinvested in additional partial shares reduces your requirement even more. Withcompound dividends at play, each quarter’s reinvestment growsslightly. For example, a $50 stock paying a 3 percent dividendgrows by 3.03 percent per year with reinvested dividends:Goal: Ten Percent Growth per YearInitial investment1st quarter dividend 3%, reinvested share balance
$5,000.0037.50$5,037.50
2nd quarter dividend 3%, reinvested share balance
37.78$5,075.28
50
Winning with Stocks
3rd quarter dividend 3%, reinvested share balance
38.06$5,113.34
4th quarter dividend 3%, reinvested share balance
38.35$5,151.69
Compound return (151.69  5,000)
3.03%
Now to reach a goal of 10 percent growth, you need the stockto grow by 6.97 percent (10.0 percent minus 3.03 percent):Initial investment
$5,000.00
Dividend income
151.69
Capital gain, 6.97%
348.50
Total valueTotal return ($500.19  $5,000)
$5,500.1910.0%
To achieve this goal, you need the stock to rise only about 31/2points, or $350 on your investment of $5,000. Without dividends,you would need a ﬁve-point growth.This illustration makes the point that dividends play a major rolein overall proﬁts on a stock portfolio, leading to conclusions that:1. It makes sense to pick stocks yielding better than average dividends. Assuming that other fundamentals support the decisionto purchase shares in a company, higher than average dividendyield is an attractive beneﬁt. You will also discover that some ofthe best-managed companies also yield some of the best dividends—not always, but often.2. The overall goal-setting plan should be based on combined dividends and capital gains. The dividend yield is going to be a majorportion of overall return if stocks are picked wisely. It is quiteeasy to ﬁnd stocks with a 3 percent, 4 percent, or 5 percent yield.3. Reinvesting dividends in additional partial shares helps reachgoals in two ways. By reinvesting dividends, you achieve a compound return on the dividends themselves. When you achieve
51
Yield and Yield History
this by buying additional shares, you also beneﬁt from any priceappreciation, also on a compound basis.Are dividends really that signiﬁcant? How many highly ratedstocks yield well? The following list (as of October 2007) includesstocks yielding above a 4 percent dividend, with a price-earnings(P/E) ratio under 20, and with earnings growth rating by Standard & Poor’s (S&P) at ‘A.’ These criteria added together are anexample of how you can narrow a selection list of stocks:1Altria (MO)Citigroup (C)U.S. Bancorp (USB)Bank of America (BAC)Wachovia (WB)Fifth Third Bancorp (FITB)
4.23%4.934.985.245.325.51
This list includes ﬁnancial stocks with one exception, Altria, butit makes the point that you can achieve 3 percent, 4 percent, or 5percent returns on a portfolio just from dividend yield. The questionof whether a particular industry is safe is yet another issue. Forexample, ﬁve of the six stocks in this list are ﬁnancial, but is it safeto buy only ﬁnancial stocks? Given the history of the 2007 marketas an example, this sector had many problems related to the creditmarket and investments in housing but this only points out the danger of investing too heavily in any one industry. Diversiﬁcation isessential, and additional industries include companies with highyields. For example, during the same period, utility company Consolidated Edison (ED) (5.03 percent dividend) and Abbott Labs(ABT) (5.03 percent) were also on the over-5 percent list. So youcould include Washington Mutual (WM) (ﬁnance), Altria (MO)(tobacco), Consolidated Edison (utilities), and Abbott Labs (pharmaceutical) as four stocks in your portfolio. This is strongly diversiﬁed and yet the entire portfolio yielded over 5 percent.This cannot be treated as a recommendation because it appliedonly to October 2007. But it demonstrates how selection based on
52
Winning with Stocks
dividend yield and other criteria can lead to some very handsomereturns, with diversiﬁcation and high yield at the same time.
Computing the Yield: Purchase Versus Current ValueDividend yield (also called current yield) is an oddity, because itchanges in a direction opposite the movement of stock. Companiesdeclare dividends to be paid each year, usually once per quarter andexpressed as a speciﬁc amount per share. For example, the companymay declare that next year’s dividend will be $1 per share. If youown 100 shares, you will get $100 per year in the form of a dividend, probably paid out at $25 per quarter.To compute yield, divide the dollar amount of the dividend paidper year by the current price per share. This formula is shown inFigure 3-1.For example, an annual dividend of $1 per share applies to astock currently selling at $50 per share:$1 2.0%$50
The oddity of dividend calculations is seen in the way that yieldchanges when the stock price changes. Remember, the annual declaration remains unchanged for the year. In the example above, $1per share is paid out at one-fourth the annual dividend, paid quarterly. But what happens if the price per share drops to $45? Thedividend yield rises as a result:
FIGURE 3.1. DIVIDEND YIELD
dividend per share= yieldprice per share
53
Yield and Yield History
$1 2.2%$45
The more the stock falls, the greater the yield. This raises a possibility for portfolio management based on the debate over whether youshould buy more shares when prices fall. That suggestion observesthat buying at an original price and then at a lower price reducesthe overall cost of stock. If you buy 100 shares at $50 and another100 at $45, your average cost per share is $47.50.Some people suggest that you should not pay in more moneywhen prices fall, but rather seek stock for which the market price isrising. However, if you bought shares at $50 per share, it has to beassumed that you considered that a good price (perhaps based on acombination of both P/E ratio and dividend, among other criteria).But as price falls, dividend yield rises and P/E falls, making thestock even more of a bargain at the lower price. As a strategy, wellselected stock at any given price based on sound selection criteriabecomes a greater bargain if the price falls.This is only true, of course, if no other fundamental realitieshave changed. For example, if a pharmaceutical company is beingsued because its major drug proves to be dangerous, or if a company’s product has to be withdrawn because it contains lead paint,then yesterday’s fundamentals no longer apply. The test of a company’s value is based not only on the ﬁnancial ratios and trends, butalso on the basic competitiveness of the company within the market.As long as none of those market factors have changed, dividendyield is strategically important to you. Remember, the lower theprice, the greater the dividend yield, because the dividend dollarvalue is ﬁxed for the full year, even if the stock’s price drops.Does this mean the company is less valuable if the stock’s pricerises? Here again, there is a contradiction. The higher the pricegoes, the lower the dividend yield. If a $1 per share dividend isdeclared when the stock sells at $50 per share, it is a yield of 2percent. But if the stock rises to $60 per share, the yield is reduced:$1 1.7%$60
54
Winning with Stocks
Just as some people think you should buy more shares when stockprices fall, others believe you should buy more shares when pricesrise. This dollar-cost averaging strategy usually calls for investing aﬁxed dollar amount every month, as an example. But when a stock’sprice rises, the consideration of dividend yield (and P/E) work adversely. Dividend yield is lowered but P/E rises as the stock’s pricerises. At such times, if you accept the lower current yield and higherP/E but still believe the stock is a bargain at that price, there is noreason to stay away. However, if you prefer higher yields and lowerP/E ratios, you can seek other stocks whose price rise has not yetoccurred.
Dividend History as a Crucial TestCurrent yield is a useful test of a company’s value, not only to reduce a list of potential investments but also to improve annualproﬁts. Most people emphasize price change while ignoring dividend yield. If you set a proﬁt goal, include dividends as part of thatgoal; you are likely to discover that dividends play a major part inthe overall proﬁtability of well-managed companies.Looking beyond current yield, dividend history can provide further information for picking or eliminating companies as potentialinvestments. You will ﬁnd a rather large number of stocks yielding3 percent, 4 percent, or 5 percent (or more) at any given time. Ifthe total is well over 300 stocks, how do you eliminate these downto a more realistically sized list? Even if you seek highest-ratedstocks and look only in a speciﬁed P/E range, the list remains large.As of October 2007, the number of stocks yielding more than 4percent, rated with the high credit risk of ‘A’ and with P/E under20, exceeded 70 stocks.2Another way to use dividends to pare down the list is to checkthe history of dividend growth over several years. Mergent Company publishes a quarterly summary of its ‘‘Dividend Achievers,’’stocks whose dividends have increased over 10 years or more.These stocks have consistently outperformed market-wide indiceslike the S&P 500, and by mid-2007, 312 companies met this impor-
Yield and Yield History
55
tant standard. That is about 10 percent of North American companies that pay dividends to stockholders. The company’s Web site, athttp://www.dividendachievers.com, reported that nearly half of thecompanies on its 2007 list had actually seen annual dividend growthover more than 20 years, and that 98.5 percent of the companies onthe list were proﬁtable with lower volatility than typical stocks.In other words, these dividend achievers represent one important method for reducing the list of potential stocks. But why is thisso? A company that is able to increase its dividend every year over10 to 20 years has adequate cash ﬂow to be able to make paymentsto its stockholders. In comparison, companies having cash ﬂow difﬁculties cannot pay ever-higher dividends due to cash shortages. Soyou can analyze cash ﬂow with a series of ﬁnancial ratios over time,or you can simply study the dividend history of a company to decidewhether management is doing a good job. It is accurate to assumethat when a company increases its annual dividend, management isbetter than average.The four companies previously mentioned, all yielding over 5percent dividend, all met the 10-year dividend achiever test throughﬁscal 2006. Your criteria for low to medium P/E, high credit rating,and high dividend could be further narrowed by looking only fordividend achievers. Table 3-1 shows the 10-year history for the fourstocks used in the previous high-dividend example.Accompanying the test of dividends is a question related tooverall capitalization. Check the dividends, but also keep an eye onthe debt ratio (more on this in the next section). There is a naturalconﬂict between stockholders (equity investors) and bondholdersor lenders (debt investors). The two together provide capitalizationto the company and each gets a slice of the pie. Stockholders getprice appreciation in a well-managed company as well as dividendsif and when these are paid. Debt investors get interest on moneyloaned. Bondholders are usually paid before common stock ownersin the event of liquidation. So if the company goes broke and sellsoff everything, a debt investor has an advantage over an equity investor. But as long as your company remains in business and is wellmanaged and competitive, price appreciation is a major beneﬁt ofowning stock.
56
Winning with Stocks
TABLE 3-1. HIGH-YIELDING DIVIDEND ACHIEVER STOCKS
Dividend per ShareAbbottLabsAltria
Year
ConsolidatedEdison
WashingtonMutual
20062005200420032002
$2.302.282.262.242.22
$1.161.091.030.970.92
$3.323.062.822.642.44
$2.061.901.741.401.06
20012000199919981997
$2.202.182.142.122.10
$0.820.740.660.580.52
$2.222.021.801.641.60
$0.900.760.650.550.47
Source: Standard & Poor’s Stock Reports
When price appreciation is combined with a healthy dividend,you are in the best position of all. But a hidden danger is the creeping long-term debt. If debt begins to rise over time, the companycould be headed for trouble. The higher the debt, the greater the‘‘debt service’’ (requirement to repay the amount borrowed, plusinterest). And the higher the debt service, the less working capitalremains for dividend payments. If the debt level exceeds the company’s rate of growth, dividends will stop growing as well.
Dividends Versus Interest: Total CapitalizationTotal capitalization is one of the most important features to beaware of. It represents the overall source of capitalization for thebusiness and contains two segments. First is the value of net worth,also called stockholders’ equity. This is the combination of capitalstock and retained earnings (the net of all proﬁts or losses). Theequity portion of total capitalization is only part of the story, however. The rest is debt capitalization, which is identiﬁed on the bal-
57
Yield and Yield History
ance sheet as long-term debt. This includes long-term notes,contracts payable (business loans, mortgages, etc.), and bonds. Thelevel of debt can be quite low or very substantial. Some companiescarry little or no debt, whereas a few have very high debt. GeneralMotors, for example, reported that debt represented 115 percent oftotal capitalization at the end of 2006, an extreme case. This meansthat the equity portion was negative. In GM’s case, it was more than$5.4 billion in the red.Total capitalization is a critical test of how well companies manage their cash, and how heavily they depend on debt versus equity.The formula for total capitalization is summarized in Figure 3-2.For example, if long-term debt (in millions of dollars) is $2,714and total equity is $1,388, total capitalization will be $4,102:$2,714
$1,388  $4,102
To compute the all-important debt ratio, divide long-term debtby total capitalization. This ratio, expressed as a percentage, showscurrent status as well as the trend in debt levels. It is summarized inFigure 3-3.
FIGURE 3.2. TOTAL CAPITALIZATION
long-term debt + total equity
=
total capitalization
FIGURE 3.3. DEBT RATIO
long-term debt= debt ratiototal capitalization
58
Winning with Stocks
For example, if long-term debt (in millions of dollars) is $2,714and total capitalization is $4,102, the debt ratio is 66.2 percent:$2,714 66.2%$4,102
Additional typical examples and comparisons are summarized inTable 3-2.In this comparison, dissimilar years are reported because ﬁscalyears end in different months. But in each case, these are the latestavailable results as of fall 2007. Note the vast differences amongthese three companies. Microsoft (MSFT) carries virtually no debt,so its working capital risk is practically zero. In comparison, WalMart (WMT) carries a consistent debt equal to about one-third of
TABLE 3-2. DEBT RATIO AND TOTAL CAPITALIZATION
Long-TermDebt
In Millions of DollarsTotalCapitalization
DebtRatio
Company
Year
Microsoft
20072006200520042003
$
00000
$31,09740,10448,11574,82562,751
0%0000
Wal-Mart
20072006200520042003
$30,73530,17123,66920,09919,608
$94,46884,80974,38865,20660,307
32.5%35.631.830.832.5
Eastman Kodak
20062005200420032002
$ 2,7142,7641,8522,3221,164
$ 4,1024,7315,6635,5663,941
66.2%58.432.741.429.5
Source: Standard & Poor’s Stock Reports
59
Yield and Yield History
total capitalization, and this trend has not changed over a ﬁve-yearperiod even though the company experienced considerable growth.Eastman Kodak (EK), however, has experienced a rising debt ratio.In ﬁscal 2002, debt was only 29.5 percent of total capitalization, butat the end of 2006 it had more than doubled to 66.2 percent.Dividend declarations may change for a variety of reasons. Butit is interesting to note that the dividend trend for these three companies was related to the trend in the debt ratio. Table 3-3 summarizes the dividend history for the same period.Microsoft and Wal-Mart both increased their dividends for eachyear reported, in line with increasing revenues and proﬁts. However, Microsoft also carries no debt and Wal-Mart was able to contain its debt to the same level while its markets grew. Kodak’s story
TABLE 3-3. DEBT RATIO AND DIVIDENDS
Company
Year
DebtRatio
Dividendper Share
Microsoft
20072006200520042003
0%0000
$0.390.340.32*0.160.08
Wal-Mart
20072006200520042003
32.5%35.631.830.832.5
$0.670.600.520.360.30
Eastman Kodak
20062005200420032002
66.2%58.432.741.429.5
$0.500.500.501.151.80
* Microsoft’s reported dividend excludes a one-time $3.00 per share dividendSource: Standard & Poor’s Stock Reports
60
Winning with Stocks
was not as successful. Its overall dividend declined from $1.80 to$0.50 per share over the period, and for the past three years thedividend remained at the same level without any growth. In fact,given the rise in the debt ratio, even that level of dividend paymentseems unjustiﬁed.Dividend and debt ratio history are revealing when analyzed together. The situation often reﬂects the trend in proﬁts as well. Forexample, during this period both Microsoft and Wal-Mart reportedstrong growth in proﬁts, but Kodak reported diminishing proﬁtseach year (in millions of dollars):
Year
Proﬁt(loss)
20062005200420032002
( 600)(1,455)81238793
It makes sense. A company that is losing money as its marketshare declines (or, in the case of Kodak, when its primary productis becoming obsolete as in the case of old-style ﬁlm for cameras),it is impossible to continue increasing dividends every year. Thecompanies that are able to reﬂect growth in dividends per sharewhile keeping long-term debt in check are effectively managing cashﬂow, remaining competitive, and rewarding stockholders with notonly dividends, but with ever-higher stock prices as well.
Calculating Total Return: Capital Gains PlusDividendsThe inclusion of dividends as part of overall return is necessary ifyou expect to make realistic comparisons between stocks. Somecompanies pay exceptionally high dividends, including those above5 percent; others pay very low dividends or none at all. Some very
61
Yield and Yield History
large corporations pay dividends at quite a low rate as of 2007,including Exxon-Mobil (XOM) (1.5 percent), IBM (1.4 percent),Microsoft (1.5 percent), Target (TGT) (0.95 percent), and WalMart (1.95 percent). Xerox Corporation (XRX) pays no dividends.If you want to compare these companies to those yielding above 5percent, you need to include dividend yield.The basic calculation of return from investment in stock is todivide the proﬁt by the original net cost (price paid plus transactionfees including margin interest, if applicable). Figure 3-4 shows thiscalculation.For example, if you bought 100 shares of stock at $50 per shareand paid $5,012 (including transaction costs) and later sold thestock at $56 per share, receiving $5,588, your return is:$5,588  $5,012 11.5%$5,012
The proﬁt of $576 represents 11.5 percent, but by itself, this ismeaningless. For example, if you achieved an 11.5 percent returnon two stocks, they would be vastly different if your holding periodwas not identical. In order to make valid comparisons between investments, you need to annualize the returns. This means adjustingthe return to what it would have been if the holding period wasexactly one year.To annualize, divide the return by the holding period (inmonths) and then multiply by 12 (months). This formula is shownin Figure 3-5.
FIGURE 3.4. PROFIT FROM SALE OF STOCK
sales price – purchase price= profitpurchase price
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Winning with Stocks
FIGURE 3.5. ANNUALIZED RETURN
(
returnholding period
)
x 12
= annualized return
For example, the 11.5 percent return will be vastly different ifthe holding period is shorter or longer than one year:Three-Month Holding Period(11.5%  3)  12  46.0%
Fifteen-Month Holding Period(11.5%  15)  12  9.2%
The longer the holding period, the lower the annualized yield.The difference in this example between 3 and 15 months is vast. Itis essential to go through the annualization to make sure you aremaking like-kind comparisons.Dividends have to be included in the calculation, but you donot need to annualize the rate of dividend return. This is especiallycomplex if you reinvest dividend income in additional partial shares.If you begin with the calculation based on total dollar value and thenannualize total capital gain and dividend together, you get a fairlyaccurate picture. Dividend income does not distort the total.However, it remains important to include dividend income.For example, if your 100-share investment was made in two identically priced stocks at the same time, will total return calculationsbe the same? If one stock paid 5.25 percent and the other paidno dividend, a 12-month holding period outcome would be quitedifferent:
63
Yield and Yield History
Stock Paying 5.25% Dividend100 shares sold after 12-month holding periodless original cost
$5,5885,012
capital gain
$ 576
dividend, 5.25% at purchase value $5,012
263
total return
$ 839
total yield ($839  $5,012)
16.7%
Stock Paying No Dividend100 shares sold after 12-month holding period
$5,588
less original cost
5,012
capital gain and total returntotal yield ($576  $5,012)
$
57611.5%
This demonstrates the signiﬁcance of dividend yield. The capitalgains on stock sales may be marginal in percentage terms. For example, a $250 proﬁt on a $5,000 investment is only a 5 percentreturn without considering annualization. If that stock yielded a5.25 percent dividend, then you earned more from dividends thanfrom sale of stock.Calculating yield is not difﬁcult. It is a key indicator for a stock,especially when looked at in a historical context. Making realisticcalculations of actual outcome with annualization in mind affectscomparisons as well; clearly, a return on holdings of a few monthsis not the same as one for stock held for more than a full year.Yield is one way to judge value and to make value judgmentsabout stocks. Another way is to review the past in order to predictthe future of price movement, hoping to ﬁnd stocks with the greatest potential for price appreciation. Managing risk is a balancing actbetween this proﬁt opportunity and market volatility. In the nextchapter, the well-known Dow Theory is explained in a differentcontext than its familiar application. It is usually applied to thewhole market, but its principles can also be valuable in analyzingindividual stocks.
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Winning with Stocks
Notes1 Source: Charles Schwab & Co. brokerage Web site at https://investing.schwab.com.2 Ibid.
C
H
A
P
T
E
R
4
THE ‘‘PRACTICAL’’DOW THEORY
A
lot of emphasis is placed on the Dow Jones Industrial Average(DJIA), an index of 30 large-cap companies. However, in spite ofthe popular belief, the Dow is not ‘‘the market,’’ only a sample ofstocks. While the DJIA is widely followed and believed to indicatewhat is going on in the market, it is not always true, especially whenit comes to a study of the value in each and every stock. There aretwo considerations: trends in the broad market that are found inthe indices, and trends in the individual company that are found inmovement of its stock price.The origin of the Dow Theory is traced back to the founder ofthe Dow Jones Company and publisher of what has become the WallStreet Journal, Charles Dow. However, Dow developed his ideas asa method for studying business trends, that is, sales and earnings.Today, the same theory is invariably applied to the broader marketas deﬁned by the DJIA. Because it is general in nature, it tells theinvestor absolutely nothing about whether the timing is right to buy,sell, or hold a speciﬁc stock.This chapter shows how the principles of the Dow Theory can65
66
Winning with Stocks
be applied with effectiveness to individual stocks held in a portfolio.The cornerstone ideas of identifying primary movements and conﬁrming them separately works well for individual stocks, but suchan approach is rarely used. Among the means for identifying suchtrends in stocks, the all-important subjects explained in the ﬁrst twochapters work as essential elements in the study of a stock’s trend.As the basis for the very premise of technical analysis, the DowTheory can be useful in employing technical tests: trading range,price volatility, and support/resistance.
How Indexing Works: Weighted AveragesThe Dow Jones Industrial Average is just that, an average of pricemovement among 30 industrial stocks. Collectively, these 30 stocksrepresent nearly 24 percent of the overall market capitalization ofU.S.-based publicly listed companies, making the index