Relative Dividend Yield
With an elevated relative dividend yield, one gets paid to wait for a company's prospects to turn around at a price that still offers significant capital appreciation opportunity
For dividend-paying companies used in its ValuePlus strategy, one preferred valuation metric SKBA uses to screen investments is Relative Dividend Yield (RDY). Relative Dividend Yield is calculated by dividing a company's dividend yield by the dividend yield of the SKBA Dividend 500 index. SKBA uses this proprietary index of 500 large-cap, dividend-paying companies that are traded on U.S. exchanges as the denominator of the ratio. RDY is on a percentage basis, so a company with a 160% RDY has a 60% higher dividend yield than the SKBA Dividend 500.
The time horizon and fundamental underpinnings of RDY fit well with our valuation principles in evaluating the attractiveness of mid-to-large sized dividend-paying companies. For many mid-to-large companies that pay dividends, the payment of and growth in the dividend are signs of success in managing one's business and finances. Dividend policies are set in response to the management's and board's view of the long-term/underlying earning power of the company, not on reported earnings (which may not be indicative of underlying profitability). A reduction or increase in the dividend is highly indicative of management's outlook towards changes in underlying earning power. As a result, changes in dividend policy relative to a company's history hold tremendous value in assessing a company's prospective changes in fundamentals.
As a valuation measure, this information is not widely used by investors. RDY tends to go against the consensus thinking of Wall Street, capturing low expectations that may already be discounted in a stock's current price. Few methods capture and take advantage of the dysfunctional behavior of investors as their attitudes and sentiments repeatedly swing from extreme optimism to distress and pessimism. Unlike the use of absolute yield, which holds little if any informational value, highs and lows in RDY represent valuation extremes that can often be exploited in generating excess returns. Downside risk can often be reduced by purchasing high RDY companies (compared to their own histories and above a market yield) that pay sufficiently high yields on an expected value basis to enable us to be patient and get paid to wait for the prospects and stock price to improve.
As in the case of the industrial company shown nearby, the annual dividend rate is far less volatile than the last twelve months change in reported earnings, making it a better indicator of the long-term trend in profitability over the last twenty years.
In addition, each company's RDY is compared to its own history. In SKBA's opinion, RDY has been a more reliable signal of valuation attraction compared to the price-to-earnings ratio. In this example, the company has not cut its dividend over this time horizon, signaling a confidence in the business despite weathering significant earnings downdrafts around the turn of the millennium, in 2009, and again in 2013. The best time to buy this industrial company in hindsight would have been at the upper end of its historical RDY range.
RDY is merely an initial metric and does not take the place of fundamental research. At times, companies that reach elevated RDYs consider cutting dividends; this is somewhat more common in cyclical companies. Dividend cuts usually are negative events for valuation, fundamentals, and total return. Balancing the risk of dividend cuts against the reward of purchasing at depressed valuation requires more effort than simply looking at a chart.
From a portfolio construction standpoint, investing in companies with high RDY compared to their own histories, as opposed to the absolute yield level, prevents the portfolio from becoming a bond substitute with an excessive correlation to interest rate changes. Relative dividend yield is a powerful tool, highlighting companies that are truly out-of-favor, produce income, provide downside protection, and generate capital appreciation over long-term holding periods.

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Last updated: June 03, 2015

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