Yield-Based Valuations

A dividend yield is the percentage of a company's stock price that it pays out as dividends over the course of a year. For example, if a company pays $1.00 in dividends per quarter and it is trading at $100, it has a dividend yield of 4%. Four quarters of $1 is $4, and this divided by $100 is 4%.

Yield has a curious effect on a company. Many income-oriented investors start to pour into a company's stock when the yield hits a magical level. The historical performance of the Dow Dividend Approach supports the general conclusion buttressed by Jim O'Shaugnessey's work that shows that a portfolio made up of large capitalization, above-average yielding stocks outperforms the market over time.

Some, like Geraldine Weiss, actually invest in stocks based on what yield they should have. Weiss measures the average historical yield and counsels investing in a company's shares when the yield hits the edge of the undervalued band. For instance, if a company has historically yielded 2.5% and is currently paying $4 in dividends, the stock should trade in the $160 range. Anyone interested in learning more about Weiss's yield-oriented valuation approach should check out Dividends Don't Lie. The simplest way to take advantage of stocks that are undervalued based on their yield is to use the Dow Dividend Approach, which you can learn more about in the Fool's School area.

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