Picking Dividend Shares: The Key Ratios - Their Predictive Power and Their Interdependence



When selecting a dividend share, the three numbers that a DIY Income Investor should look at first are:

• dividend yield (dividend / share price)
• dividend cover (earnings or profit / total dividends)
• p/e ratio (price / earnings per share)

To underline, this is only the starting point for doing your own research - but these are important numbers to consider, giving an indication of the likely attractiveness and sustainability of the dividend.

And recent academic research underlines the importance of these ratios in forecasting stock returns...

A 2012 study with the catchy title "The Orthogonal Response of Stock Returns to Dividend Yield and Price-to-Earnings Innovations" (I'm still trying to get my head around 'orthogonal response') lists some of the research showing that stock returns can be predicted by dividend yield and price-to-earnings among many other factors: 

• Blume (1980) empirically documents a positive and significant relationship between stock returns and dividend yields.
• Litzenberger and Ramaswamy (1982) and Morgan (1982) provide evidence of a positive and nonlinear relationship between stock returns and expected dividend yields.
• Kiem (1985) reports the association between stock returns and dividend yields; the relationship is due to a nonlinear association between returns in the month of January and dividend yields.
• Campbell and Shiller (1988) examine the relationship between dividend yields and stock returns in the introduction of the dividend yield model.
• Fama and French (1988) show that stock returns can be predicted by dividend yields.
• Hodrick (1992) reports that changes in dividend yields significantly forecast expected stock returns.
• The relationship between returns and dividend yield is also documented in a study conducted by Naranjo, Nimalendran and Ryngaert (1998).
• Jiang and Lee (2007) also show excess stock returns can be predicted by a linear combination of log book-to-market ratio and log dividend yields.  

The relationship between stock returns and price-to-earning (P/E) ratio has also been studied:

• Basu (1977) empirically shows that lower P/E stock portfolios generate higher risk-adjusted returns than portfolios of high P/E stocks.
• A similar finding is reported in a study conducted by Peavy and Goodman (1983).
• Campbell and Shiller (1998) show the increase in P/E ratio are followed by the lower growth in stock price.

(Full references are given in the study - if you have enough appetite for this kind of stuff!)

 

The conclusion of the study (into the S&P500 using monthly data from 1871 to 2012): "The results of
the Granger causality tests indicate that dividend yield and price-to-earnings cause the movement in stock returns."

Another recent study of the Malaysian Stock Market quotes a further range of studies (with references): 

• related to dividend price ratio or dividend yield: Campbell and Shiller (1988, 1998); Lo and McKindley (1988); Poterba and Summers (1988); Fama and French (1988); Goetzmann and Jorian (1993); Hodrick (1992); Khothari and Shanken (1992)
• related to price earning (P/E) ratio: Basu (1975); Lamont (1998)

This study also carries out a 'state of the art' analysis of these factors on the Malaysian Stock Market and concludes that:

"The empirical evidence points to the direction that there is significant short run Granger causality among stock returns, dividend yield and price earning with the most significant direction being from dividend yield to stock returns. The finding suggests that market player should use fundamental variables in deciding their investment strategies since it is an important source of information in determining stock market returns,"
So that's OK then.

However, don't forget that these ratios are mathematically connected. and this gives some interesting relationships. To recall:

• dividend yield = 100 * dividend / price
• dividend cover = earnings / dividends
• p/e = price / earnings

Assuming, for simplicity, that the dividend cover = 1. This means that earnings and dividend payments are equal: under that assumption, dividend yield = p/e. With this as the starting point, imagine the following:

• assume that the earnings double (while everything else stays the same). This means that the dividend cover = 2. The dividend yield remains the same; however, the p/e is halved.
• alternatively assume that the price doubles, the dividend yield will halve and the p/e will double (dividend cover is unchanged)
• finally, assume that the dividend doubles, the dividend yield will double, the dividend cover will halve but the p/e is unchanged.

What is interesting about this little 'thought exercise' is how these ratios are connected. To summarise, from the initial starting position (where dividends = earnings):

• an increase in earnings is positive for dividend cover and p/e (it does not affect the yield)
• an increase in price is negative for both dividend yield and p/e (it does not affect the dividend cover)
• an increase in dividends is positive for dividend yield but negative for dividend cover (and neutral for p/e)

So, how can you use this knowledge when picking dividend shares? The first conclusion is that the point when all of these ratios are in the 'sweet spot' may well be fleeting and temporary: you might need to act fast (particularly in a recovery situation).

Second, you need to know what you are looking for:

• dividend yield, looking for something around 5% but less than 8%
• dividend cover, looking for a number higher than 1.5
• price/earnings ratio (p/e), looking for less than 10 (remember, 'earnings' = 'profit')

Third - and fairly obviously, look at the forecast figures:

• if forecast yield is different from the current yield, ask yourself: why? If the yield is quite high, this will usually be due to a collapse in the share price: find out why.
• look at forecast earnings: higher earnings are good all round - they will support a higher price (via the lower p/e) and a higher dividend (via a higher dividend cover).
• then look at the forecast dividend: normally you would expect this to be higher than the current dividend; if not, why? Is the current cash flow/profitability poor?

Looking at the price trend can also be helpful: is there a pronounced slope upwards or downwards over the previous months? If the price is trending lower, then this might explain the high yield - also waiting will give you a better (lower) p/e and better (higher) yield. Waiting will also give you time to find out exactly why the market doesn't like the share - and time to decide whether or not you think the market is right.

If the price is trending upwards and the yield is still attractive (perhaps after a previous price fall), you might have found a winner!

Remember, however, to check the other key factors such as debt, cash flow and sustainability of the business model in a competitive market.

Good luck!


I am not a financial adviser and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.