As an accountant, it is my job to offer financial advice and help a client report and organize their finances such that they make the best decisions for them. Often time a client will own stocks, and while I am not able to offer investment advice, I can share some general information about how to evaluate stocks.
A major consideration for investors is an investment’s yield, which indicates the value of the payments you’ll receive. Yield can be a great tool in considering whether you’d rather try to generate future income from bonds or stocks, and whether its price is appropriate.
Dividend yield reflects how much of a company’s value gets passed on to shareholders. To calculate it, divide the annual dividend by the price for a share of the common stock. For example, if a stock offers a $1.75 annual dividend and its share price is $50, its dividend yield would be 3.5%.
A stock’s yield helps determine whether a stock is under or overvalued relative to projected income. The dividend discount model uses dividend yield to calculate what the current value of a stock should be based on its anticipated dividends in the future. If dividends are expected to grow rapidly, the present value of a stock should be higher than if dividends are expected to remain relatively static.
Dividend yield only goes so far as a valuation tool. A company isn’t worthless just because it may not pay dividends, and the calculation is only as good as the assumptions it’s based on. A company can always cut its dividend, in which case the present value of that income stream–and presumably the stock’s price–would drop. A company’s growth rate may vary over its life cycle; trying to guess when dividends might change and by how much makes the dividend discount calculation even more challenging.
In addition to being a tool for evaluating individual stocks, yield can be used to assess the relative value of the stock market as a whole. A method informally known as the Fed model can help you estimate whether stocks are overvalued or undervalued relative to bonds. It should be noted that the Fed model is not officially endorsed by the Federal Reserve.
Though there are variations on the method, the original model compares the yield on the 10-year Treasury note to the forward-earnings yield per share of the S&P 500. Earnings yield is calculated in much the same way as dividend yield is: by dividing the per-share earnings forecast (rather than the anticipated dividend) for the next 12 months by the current share price. If the result is lower than the yield to maturity on a 10-year Treasury note, stocks might be overpriced. Why? Because the Treasury note offers a higher yield that involves less risk. On the other hand, if the forward-earnings yield on stocks is higher, then you’re at least being compensated for the higher risk involved with stocks.
However, for the average investor, the model also has flaws. If earnings prove weaker than predicted, actual stock yield might not be as high, which would throw off the comparison. Also, using trailing earnings over the previous 12 months rather than forward earnings as your yardstick would give you a different result. Dramatic swings in Treasury prices can make stocks seem less expensive than they might be when compared to their historical performance. And even if equities or bonds appear cheap, there’s no guarantee either one won’t be an even better bargain in the future.
Managing stock investments is complex, and something that requires special attention to detail. Always consult your financial advisor before making investment decisions–and let your accountant know what purchases and sales were made during the year so that proper reporting can take place.
Scott Boyer, CPA