A stock’s P/E ratio and dividend yield are probably the favorite investor metrics to analyze the valuation of companies. They are seen as being indicative of what the stock can generate for us. We analyze the important relationship between the P/E ratio and the dividend yield.
Before diving into the relationship between the P/E ratio and the dividend yield, it is worth highlighting that no stock analysis can be complete by looking at only these two metrics. There are many other important data point that have to be considered, including the price-to-sales ratio, the leverage, growth rates, the competitive landscape, and even macroeconomic conditions.
Let us start by look at the formulas used to calculate both the dividend yield and the P/E ratio:
Dividend Yield = Dividend Per Share / Share Price
P/E Ratio = Share Price / Earnings per share
As you can see, there is something in common in these formulas: the price per share. In fact, we can invert the formula used to calculate the P/E ratio in order to find out a stock’s earnings yield:
Earnings Yield = Earnings Per Share / Share Price
Let us use the Swiss pharmaceutical company Novartis as an example. As of June 17th, 2020, Novartis was trading at CHF 85.10. Its earnings per share in 2019 was CHF 3.91:
P/E Ratio = 85.10 / 3.91 = 21.8
Earnings Yield = 3.91 / 85.10 = 4.6%
Thus, the share price was 21.8 times the annual profit. Conversely, we can also say that annual profits are the equivalent of 4.6% of the stock price.
Because the earnings yield is a percentage, it can be compared directly with the dividend yield. As a result, while the dividend yield indicates how much cash the company is paying to shareholders every year, the earnings yield indicates how much profits the company is generating for shareholders.
Sustainability of Dividends
While some investors look at past dividends to assess how sustainable a company’s dividends are, there something more useful than that. We need to look at the prospect for future profits. Dividends are only sustainable in the long term if they are financed with profits.
If dividends are being financed by borrowing money, divesting of assets or using reserves, they will be cut at some points and the company’s financial situation will be very dire.
If we want to know if dividends will be sustainable in the long term, we need to make sure that enough profits are being generated both today and in the future.
Dividend Payout Ratio
If we take the earnings yield and the dividend yield, we can calculate the dividend pay-out ratio. The dividend payout ratio is the percentage of profits that are used to finance dividends. The higher this percentage, the more profit are paid out to shareholders in the form of dividends and the less is being reinvested into the business.
There is nothing wrong with paying out large dividends if they are sustainable. Large dividends mean that the company is already mature and has fewer growth opportunities. Therefore, if we focus on companies with high dividends, it is very unlikely that we will experience stock price appreciation.
However, if that is your preference, that is fine. In that case, we need to pay attention to the dividend payout ratio.
A dividend pay-out ratio above 80% can be considered a red flag. That would imply that just enough is being reinvested to keep the business running. In such cases, we would need to make sure that such little reinvestment will be enough to maintain the business as is.
If the dividend payout ratio exceeds 100%, we need to start worrying. This would indicate that part of the dividend is being financed with either reserves or debt. It tells us the company is not making enough money to pay those dividends by achieving profits. An extreme version of that would be a money-losing company paying dividends.
In the case of Novartis, the Swiss company paid a dividend of CHF 2.95 in 2020:
Dividend Payout Ratio = Dividend per share / Earnings per share = 2.95 / 3.91 = 75% or, alternatively, Dividend Yield / Earnings Yield = 3.4% / 4.6% = 75%
The main takeaway of analyzing the relationship between the P/E ratio and the dividends paid by a company is to not get lured by a high dividend yield alone. In general, if a company has a high, sustainable dividend yield, it must also have a low P/E ratio.
Assuming a dividend payout ratio of 70%, if a company pays a dividend yield of 5%, the earnings yield should be at least 7.1% (5/0.7). If we inverse that, we will realize that the P/E ratio cannot be higher than 14 (1/0.071).
Similarly, and using the same 70% dividend payout ratio, a company paying a dividend yield of 7% would need an earnings yield of at least 10% (7/0.7), which corresponds to a price-to-earnings ratio of no more than 10 (1/0.10).
The following circumstances tend to lead to low P/E ratios and, therefore, potentially high dividend yields:
- Low or no growth. Perhaps even a declining business.
- Structurally unattractive sectors due to low margins, high costs, heavy regulations, etc.
- Highly indebted companies, which indicate higher risk
- Undervalued companies
As you can see, there might be nothing wrong with a company that is trading cheap, with a low P/E and a high dividend yield. This would be the case with undervalued companies.
Undervalued companies do exist, but it requires a lot of work to identify them. The P/E ratio and the dividend yield can be a good start, but you will need a lot more pieces to complete the puzzle.
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