Valuation is the main problem to solve with stock investing.
Essentially, there are three basic methods used by dividend investors: price to earnings ratio, average stock yield, and variations on a perpetuity calculation (such as the dividend growth model).
Price to earnings ratio (P/E) is very easy to apply. A stock is bought when the price to earnings ration is below a historic average. The average stock market P/E of 15 to 16 is used by many. The main issue with this technique is that some stocks trade at a premium to the stock market average, while others trade at a discount. Therefore, this method works best when you know that stocks historic average.
The average stock yield method is similar; however, the historic average yield for a stock is used.
I personally don't like the above two methods, since a database of historic averages is required and it really doesn't address the case where stock market or company conditions are not average.
I prefer to use a perpetuity method where the stock price is calculated by dividing the benefit by a discount rate. A perpetuity is a bond without a maturing date. For the basic perpetuity calculation, the periodic payments are divided by the perpetuity's interest rate.
The dividend growth model uses earnings as the benefit with the discount rate being the total return rate minus the dividend growth rate. The main problem with this model is that it is mathematically unstable. The total return rate is largely a guess and using the historic dividend growth rate can cause a negative price.
I prefer using the dividend as the benefit with the corporate bond index yield as the basis of the discount rate. The dividend can be adjusted to the average considering growth over a given period (I use 5 years). The current inflation rate is subtracted from the bond yield to get discount rate. Stocks should rise in value with inflation, while bonds have a fixed value, so inflation must be included in the yield. This provides a direct calculation of an income stock's value compared to its principle competitor, corporate bonds. It will not work with low yielding stocks.
As an additional warning. Stocks which have problems, such as high payout ratio and high debt, should be eliminated prior to performing the valuation calculation.
A good reference to valuation is The Little Book of Valuation. It is written by a finance professor who specializes in valuation techniques. I think it is more relevant to a professional rather than an amateur; however, it is a good discussion of the principles.
Essentially, there are three basic methods used by dividend investors: price to earnings ratio, average stock yield, and variations on a perpetuity calculation (such as the dividend growth model).
Price to earnings ratio (P/E) is very easy to apply. A stock is bought when the price to earnings ration is below a historic average. The average stock market P/E of 15 to 16 is used by many. The main issue with this technique is that some stocks trade at a premium to the stock market average, while others trade at a discount. Therefore, this method works best when you know that stocks historic average.
The average stock yield method is similar; however, the historic average yield for a stock is used.
I personally don't like the above two methods, since a database of historic averages is required and it really doesn't address the case where stock market or company conditions are not average.
I prefer to use a perpetuity method where the stock price is calculated by dividing the benefit by a discount rate. A perpetuity is a bond without a maturing date. For the basic perpetuity calculation, the periodic payments are divided by the perpetuity's interest rate.
The dividend growth model uses earnings as the benefit with the discount rate being the total return rate minus the dividend growth rate. The main problem with this model is that it is mathematically unstable. The total return rate is largely a guess and using the historic dividend growth rate can cause a negative price.
I prefer using the dividend as the benefit with the corporate bond index yield as the basis of the discount rate. The dividend can be adjusted to the average considering growth over a given period (I use 5 years). The current inflation rate is subtracted from the bond yield to get discount rate. Stocks should rise in value with inflation, while bonds have a fixed value, so inflation must be included in the yield. This provides a direct calculation of an income stock's value compared to its principle competitor, corporate bonds. It will not work with low yielding stocks.
As an additional warning. Stocks which have problems, such as high payout ratio and high debt, should be eliminated prior to performing the valuation calculation.
A good reference to valuation is The Little Book of Valuation. It is written by a finance professor who specializes in valuation techniques. I think it is more relevant to a professional rather than an amateur; however, it is a good discussion of the principles.