There are a lot of different ways to find undervalued stocks. One that doesn't get a lot of attention is relative dividend yield. If you aren't using this tool to find historically cheap stocks you could be missing out. Here's a look at how investors can find undervalued stocks using this metric.
The normal valuation path
One down-and-dirty way to find cheap stocks is to simply look for companies whose stock prices just hit new 52-week lows. By definition, these companies are beaten down. Price alone, however, can't tell you if they are value stocks. Indeed, the company's fundamental performance may be so bad that a steep price decline is fully justified. This is why most investors also look at other valuation metrics.
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Some of the go-to ratios include price-to-sales (P/S), price-to-earnings (P/E), price-to-book value (P/B), and price-to-cash-flow. The P/S and P/E ratios look at the top and bottom lines of the income statement, the P/B ratio uses the balance sheet, and price-to-cash-flow ratio examines the cash flow statement. So, as a group, they cover all of the major financial statements. There are pros and cons to all of them. For example, earnings tend to be a lot more volatile than sales, so P/Es tend to move around a lot more than P/S ratios.
But there's another metric that investors should be looking at when looking for value and that's the dividend yield. Of course, this valuation metric only applies to stocks that pay a dividend. But for those that do, it can offer real insight.
The key is to consider the dividend yield relative to both the broader market and a company's own yield history. Essentially, if the yield is abnormally high in some way it is worth looking at the stock. You need to tread carefully because high yields are often a sign that a company is struggling. That could mean a dividend cut is near. But if you are confident in a company's financial strength and business outlook, a historically high yield could also be a great buying opportunity.
A good place to make use of relative dividend yield is with companies that have a proven history of returning value to investors via dividends, like the Dividend King list. Though 10 years of annual increases is probably a reasonable starting point for evaluation based on this criteria.
Some dividend yield examples to consider
Probably one of the best examples of relative dividend yield revealing cheap stocks is ExxonMobil (XOM -0.21%) and Chevron (CVX -0.30%) in 2020. Both of these companies increased their dividend annually for decades (41 years and counting for Exxon and 36 for Chevron) despite operating in the highly cyclical energy industry. They have clearly proven their ability to reward investors through the energy cycle. Meanwhile, both have rock-solid balance sheets, with debt-to-equity ratios below those of their closest peers.
And yet, in 2020, Exxon and Chevron saw their dividend yields spike to their highest levels going all the way back to the 1990s. To be fair, the efforts used to slow the coronavirus pandemic did lead to a steep decline in oil prices, but volatility is the norm in the energy sector, not the exception. As energy prices rebounded, Exxon and Chevron saw massive stock price gains. If you had the fortitude to buy when these oil giants had historically high yields you would have made an excellent value investment.
Today, investors might want to consider stocks like Medtronic, Texas Instruments, and Hormel. All three have historically high yields, long histories of annual dividend increases, and still strong businesses. Yes, each company has its problems right now, but if history is any guide, they will muddle through while continuing to reward investors with dividend growth.
MDT Dividend Yield data by YCharts
That said, unlike Exxon and Chevron, all three of these examples have dividend yields that are more modest. The highest is medical device maker Medtronic, at roughly 3.1%. That, however, is the point of these examples. Relative dividend yield isn't just about having a huge yield, like Exxon and Chevron did in 2020. It is about having a high yield relative to a stock's normal yield history. Like all of the other valuation metrics, companies tend to trade within a yield range. There's information to be gleaned when a stock moves to the top of or even above that range.
Another tool for your valuation toolbox
When picking stocks to invest in, relative dividend yield shouldn't be used as the lone determinant. You need to consider a company's fundamentals and it is usually beneficial to examine more traditional valuation metrics alongside yield. But if you are looking to find value stocks, the relative dividend yield metric is a tool that helps you spot great investment opportunities and not just among high-yield stocks.
