The notion that high-yield dividend stocks tend to outperform the broader markets is part of Wall Street lore. In fact, this idea has roots in Charles Dow's iconic 1920 book, Scientific Stock Speculation. Reality, though, hasn't matched up with this claim in recent history.
Since the end of the era of easy money in 2022, rising interest rates have driven investors into a small cadre of mega-cap companies -- colloquially known as the "magnificent seven" -- with strong balance sheets, exceptional free cash flows, and top-shelf management teams. Meanwhile, high-yield stocks, on balance, have languished. Underscoring this point, the bellwether Vanguard High Dividend Yield Index Fund has badly underperformed the broader markets in 2023.
All that glitters is not gold
A high yield can be an enticing metric for value and income investors alike. But dangers abound in this segment of the equity market. A stock with a yield that exceeds the near 5% yield of the 10-year U.S. Treasury note (considered a "risk-free" asset) might be tempting, but investors should always bear in mind that a mouthwatering yield can also be a major red flag. More often than not, a yield above the 5% mark is the result of a falling share price in response to a stiff headwind.
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Fortunately, peer-reviewed studies have provided investors with a roadmap to select the best high-yield dividend stocks. Cutting to the chase, research shows that two valuation metrics, in particular, can be powerful indicators of a high-yield dividend stock's future performance:
Book-to-market ratio: This ratio, popularized by classic value investors like Benjamin Graham, is calculated by dividing a company's book value of equity by its market value of equity. In the world of high-yield dividend stocks, empirical research shows that companies with book-to-market ratios less than 1 tend to outperform other asset classes over the long run. The core reason is that undervalued companies with stellar dividends tend to be favored by investors under most market conditions -- with the important exception of high interest rate environments.
Earnings yield: This ratio is calculated by dividing a company's trailing-12-month earnings per share by its current share price. This metric reveals the percentage of a company's earnings per share. Like the book-to-market ratio, a higher earnings yield is associated with better long-term returns for high-yield dividend stocks.
Armed with this insight, let's examine whether Verizon Communications (VZ 1.17%) -- a popular telecom stock yielding 8.4% on an annualized basis at the time of this writing -- is a strong buy after falling by more than 14.4% year to date.
What the metrics say about Verizon stock
Verizon's book-to-market ratio is approximately 0.72. On this key metric, the telecom's stock screens as deeply undervalued.
Verizon's earnings yield stands at 14.6%. As earnings yields greater than 10% are widely considered to be a strong indicator of an undervalued company, Verizon definitely stands out on this measure.
Digging deeper, though, the story gets even more compelling. Within the landscape of blue chip stocks with dividend yields greater than 5%, Verizon screens as one of the most undervalued companies in the space from an earnings yield perspective. The graph below comparing the earnings yield of tobacco giant Altria, with its scorching 9.3% dividend yield, to Verizon illustrates this point nicely.
VZ Earnings Yield data by YCharts
Is this high-yield dividend stock a buy?
While valuation metrics are important to consider, they really are only a first step in the due diligence process. Personally, I only use the book-to-market and earnings yield ratios to scan for bargains in the high-yield dividend landscape. After that, I carefully consider a company's long-term prospects, its competitive moat, and management's track record of value creation on multiple fronts.
In this case, I think Verizon stands out as a compelling buy for long-term investors on the hunt for better-than-average passive income opportunities. The telecom giant's shares struggled earlier this year over balance sheet and competitive positioning concerns. But as the company's most recent financial results show, though, these concerns have probably been overblown by an overly pessimistic market.
So, in short, I do like Verizon stock for both its superb yield and its underlying value proposition as one of the largest wireless carriers in the United States.
