Do you prefer a high earnings yield or a high dividend yield? And why?
EDIT: Answered the wrong question. Thought you said “dividends or reinvested in the business” type question. Unffff, I need coffee.
They’re not mutually exclusive, but if you’re asking “high earnings yield but low dividend yield” vs “low earnings yield but high dividend yield” then the tie breaker is ROIC. If ROIC is high and sustainable, I’d prefer high earnings yield but low div. yield.
Unless it’s a REIT (or some other structure where earnings and dividend are substantially the same), then dividend yield is irrelevant, per M&M. Profitability (here, proxied by earnings) is important.
My value credentials are nothing special, but in general, earnings yield trumps dividend yield, unless you suspect substantial earnings manipulation (in which case the dividend yield has the advantage of actually being paid). Ultimately it’s the earnings power of the company that matters (and how that compares to business and financial risk). Whether it’s paid now as a dividend or held for later as retained earnings matters, but is typically a second-order issue. In a recession, however, dividend-paying companies are often seen as better able to withstand revenue contractions, because dividend payers are generally more mature, almost utility-like companies, and the dividend might be seen as an extra “cushion” before assets actually get eroded. Basically, dividends may be an indicator of lower risk. Given two companies with the same earnings yield, the one with the higher dividend yield is probably safer. This doesn’t consider the opportunities of growth from reinvestment of retained earnings, but in a recession, growth is generally more difficult to achieve.
Thanks AF buddies. My question basically arose after reading The Little Book That Beats the Market which espouses the Earnings Yield (specifically EBIT / Enterprise Value) as the key metric. However, another line of thinking that I was reading states that if you dissect long run returns to equities, then it is the dividend yield that is crucial because you receive hard cash. I’m trying to figure out a set of screens. I’m conscious that earnings yield as stated is pre-tax and debt distortions which is helpful in creating a level playing field. But cash is cash is cash. And paying cash keeps companies honest, sorta. Realise that I need to do more reading into this and may be losing sight of something basic, but thought I would throw it out there.
I seem to recall that that book looks for high ROA (efficient business), and then a low valuation multiple (cheap), and then maybe a little bit of momentum (protect against a value trap). Actually, maybe I don’t remember the book very well, but I definitely remember the ROA aspect (though maybe it was the very similar EBIT/EV that you quote). I remember wanting to run screens after reading that book, but got distracted by other things.
> dividend yield that is crucial because you receive hard cash 1. that doesn’t make any sense – you can always convert retained earnings into “hard cash” by selling shares. this is simply a synthetic dividend. > if you dissect long run returns to equities 2. there’s a study which demonstrates that some large fraction of total shareholder return is composed of dividend payments. Be careful here. People regularly twist this finding into the conclusion “higher dividend payers produce greater TSR” – wish I had a nickel for every time I’ve seen this on AF. I assume you can see the fault here. > may be losing sight of something basic 3. Dividends are valued by one clientele: old retail investors. It’s not a stretch to believe that they’re not the sharpest investors. You can probably convince yourself why they like dividends. 4. Institutional investors, per a 2000s-era survey, dislike dividends (compared to share repurchase). 5. If you’re a taxpayer, then you should dislike dividends. (We’re currently in a temporary situation where the dividend tax penalty is diminished, but that’s one one part of the general tax problem with dividends.) Companies pay dividends because their peers pay dividends. Economically dividends don’t benefit shareholders.
Dividends also suggest that there are no major growth opportunities justified at the company’s WACC. So if it is believable that the company can’t really grow profits at WACC or above, then it makes sense to pay dividends (or share repurchases, which are more efficient for taxable investors). The key idea here is that if a company is retaining earnings, but doesn’t have sufficient ROE, then that’s a sign that capital is being destroyed.
bchadwick Wrote: ------------------------------------------------------- > I seem to recall that that book looks for high ROA > (efficient business), and then a low valuation > multiple (cheap), and then maybe a little bit of > momentum (protect against a value trap). > > Actually, maybe I don’t remember the book very > well, but I definitely remember the ROA aspect > (though maybe it was the very similar EBIT/EV that > you quote). > > I remember wanting to run screens after reading > that book, but got distracted by other things. check out his website www.magicformulainvesting.com You’ll need to log in. DH, thanks for that. I feel like I had my wrist slapped but well worth it. Thanks all, good stuff.
Mudda I read this book some time ago (so correct me if am wrong), but one thing that struck me as odd about this “magic formula” was that you had to hold stocks for one year (or just over one year to benefit from LTCG) and then sell regardless of performance. So, you are essentially turning your entire portfolio every year. I found this to be kind of counterintuitive to the value investing philosophy.
I think the basic assumption is that if a catalyst hasn’t happened in a year, then it seems unlikely to take place in the next year. Although the position is still technically in an undervalued asset, it’s not earning fast enough and the capital should be reallocated to something that is more likely to revert to fair value. It may be that when you recompose the portfolio a year from now, the same company is on the list, in which case, you don’t have to turn it over. So maybe you want to compose the new list before you sell what you’re holding.
Earnings finance dividends. If you have a low earnings yield and a high dividend yield then your payout ratio must be quite high, which signals a lack of organic growth opportunities. It is really a case by case thing though, because I feel far too many companies (particularly traditional “growth” companies, like in tech) have a negative view of issuing dividends because it signals that their growth phase is over. I would rather a corporation be honest with itself about its prospects, rather than continuing to plow money into low return investments. Often it is much better for shareholders if the company would just accept the reality of a business cycle and start paying a dividend. I often screen on dividend yield before doing further work. I’m going to cherry pick a win for an example of why. Seedrill was yielding 12% in the aftermath of the gulf oil spill, which is an outlier to say the least. Usually when you see something like that you can determine with some cursory work that the the company will need to cut dividends in the future and the yield number is not relevant for the upcoming quarters/year. So, the time investment in pretty minimal. With Seadrill, it looked like they would be able to pay the dividend because their contract pipeline was solid, day rates were long term and their exposure to the gulf was minimal (one rig). Also, while some drillers are starting to now, many did not pay a dividend at that time. Seadrill’s high dividend was a signal of corporate health, which is why dividends can be a useful screen. The negative impact on stock price from a dividend cut is typically more severe than that from reduction of cessation of a share repurchase program. Management knows this so an astute management will only declare a dividend if they are reasonably assured of their company’s ability to pay it.
I think value investors will likely more be concerned with the fcf backing up these numbers rather than favoring either earnings or div yield…
thommo77 Wrote: ------------------------------------------------------- > Mudda > > I read this book some time ago (so correct me if > am wrong), but one thing that struck me as odd > about this “magic formula” was that you had to > hold stocks for one year (or just over one year to > benefit from LTCG) and then sell regardless of > performance. So, you are essentially turning your > entire portfolio every year. I found this to be > kind of counterintuitive to the value investing > philosophy. You are right and it is a contradiction on that basis. However Greenblatt doesn’t call it value investing and it is just a mechanical formula. However, it follows the well trodden path of value investing in looking for good businesses at low prices. Hence, MY labelling of it as value investing, at least one form of it. The basis of it is to look for companies that have 1) a high earnings yield (EBIT/Enterprise Value) and 2) a high return on capital employed (EBIT/(Net Working Capital & Net Fixed Assets. The guy is a prof at Columbia (I think it’s Columbia) and the rationale is convincing enough. But the one year holding period… The formula he proposes is backed by the historical results over a 17 year period (during the long bull market actually). The decision to hold for one year is to cut the losers just before the year to make a tax saving and thereby increase your return. So partly it is working within the US tax code system but still if you followed the actual logic he propounds, you should hold on them till they became fully valued. I imagine the data supports that one year holding period and he goes some way to backing that using compustat (maybe someone here has that data and can see how it has performed over a longer time period). The ‘evidence’ is rather neat in that his top decile picks outperform the next decile picks all the way to the bottom decile. Would have been nice if we had the data using a much longer period of history (the Elroy, Dimson, Staunton 101 year history please…). I think the one year holding period is aimed at neophyte investors who need to follow the mechanical process. The website link above even helps you do it by providing the screens on his criteria. So it could even work. Suspect that 08 was a dog of a year and 09 best year ever. In any case, I personally would apply it over a longer time basis till the stock approached fair value and then rotate. I’m keen to create my own screens and i’ve been helped out somewhat here. I get regular mail shots from investopedia & motley fool and others that scream about companies increasing dividends as the decisive factor and needed to use the sounding board of the, um, board. I am quite rusty and am now reopening the text books again. Greenblatt also takes out utilities and finance companies out of the group. I am not intelligent enough to figure out why they dont fit in this framework. Anyone have any ideas? BTW, good post BWYF BTW Palantir I hear ya, though there is more than one way to skin a cat. Presume you mean figuring out future FCF as that is the accepted ER approach. This will no doubt make you chuckle, but this guy doesnt even attempt to forecast numbers as he considers that guesstimation at best. And I find myself nodding in agreement with that assessment. Just dont tell the investors…
Muddahudda Wrote: ------------------------------------------------------- > Thanks AF buddies. My question basically arose > after reading The Little Book That Beats the > Market which espouses the Earnings Yield > (specifically EBIT / Enterprise Value) as the key > metric. However, another line of thinking that I > was reading states that if you dissect long run > returns to equities, then it is the dividend yield > that is crucial because you receive hard cash. I’m > trying to figure out a set of screens. I’m > conscious that earnings yield as stated is pre-tax > and debt distortions which is helpful in creating > a level playing field. But cash is cash is cash. > And paying cash keeps companies honest, sorta. > Realise that I need to do more reading into this > and may be losing sight of something basic, but > thought I would throw it out there. the long term average returns do depend on the return of equity via dividends, but that just proves how poorly cash is managed by corporate america. Think about this, if a company generates a lot of cash but doesn’t return it, then its asset base will increase year over year and act as a deterrent on ROIC. In this scenario the company gradually become a worse business over time thru declining ROIC and no longer screened by the magic formula.
So why holding a stock for more than 1 year makes you a neophyte investor? Have you not heard of Peter Lynch, Phillip Fisher, Warren Buffett, Eddie lampert, venture capitalists, LBO’s…Seems your mind is brainwashed by working in this shop and you seem to be losing sight of big picture…It takes sometime for the story to play out…
AstuteInvestor Wrote: ------------------------------------------------------- > So why holding a stock for more than 1 year makes > you a neophyte investor? Have you not heard of > Peter Lynch, Phillip Fisher, Warren Buffett, Eddie > lampert, venture capitalists, LBO’s…Seems your > mind is brainwashed by working in this shop and > you seem to be losing sight of big picture…It > takes sometime for the story to play out… Think you read my post wrong. Holding a stock for ONLY one year and following the mechanical process is what I was referring to. I agree long term and that’s how I would differ from his strategy.