By: Dividend Sensei
This series has explored the two most important factors in successful investing; diversification, and valuation. That’s because history shows that a well diversified portfolio of quality dividend growth stocks, bought at good to great prices, is all but certain to generate strong total returns over time. More importantly it’s something that pretty much runs itself, with little active management from investors once it’s built.
This final article will highlight the single easiest way to estimating whether or not a dividend stock is a good buy at any given time. Basically you compare the forward yield against the five year average yield. The theory is that since yields are mean reverting over time, (to a sensible level that approximates fair value), if a stock’s yield is at or above its historical yield then, assuming it’s of high quality, you can buy with confidence for the long-term.
Here’s how Dominion Energy, our go to example in this series, stacks up against this final valuation metric. According to this methodology Dominion is 31% undervalued. Now no single metric is perfect, as all valuation methods are only approximations of intrinsic value. But in this case the yield being that much higher than average indicates a good margin of safety to buy today.
Of course the ideal way to invest is to not use a single valuation method but combine a few. For example you can start by looking at a list of stocks trading at 52 week lows. Select some blue chip dividend names, such as Dominion, and then check its yield against its 5 year average yield. This gives you the benefit of knowing that a stock is not just at its most hated, (historically the best time to buy it), but also trading with a large margin of safety. Finally I personally like to check the expected future total return by adding yield to a realistic forecast for long-term dividend growth.