One Trick to Tell if the Stock Market Might Be Undervalued

Stock Dividend Yields vs. Treasury Yields

One way to calculate the relative value of stocks is to compare the dividend yield on a group of solid, blue chip companies to the interest yield you could earn by investing in Treasury bills, bonds, and notes. Today, the 10-year Treasury yields 3.83% compared to the 7.0% dividend yield on General Electric common stock, 7.0% on Harley Davidson, 4.8% on Home Depot, 3.0% on Abercrombie & Fitch, 3.1% on Johnson & Johnson, and 4.0% on McDonald’s. That’s a huge advantage for stocks when you consider that for the past decade or two, you’d have been hard pressed to find a non-financial company that not only had long-term upside growth potential but would put more cash in your pocket on more favorable tax terms (thanks to a lower dividend tax) than a Government bond.

The reason this technique tends to have merit is because at some point, dividend yields on stocks become so attractive that they basically become bonds with huge upside potential. As Benjamin Graham pointed out more than half a century ago, this is especially true in the case of companies that have no debt and pure-equity capitalization structures because the common stock of a company with no prior claims can ipso facto be no less safe than bonds in the same firm would be if issued. (This fact is often not understood by those who confuse volatility with risk. They are not the same thing.)

In other words, when sustainable dividend yields - that is, dividend yields that you can be fairly certain aren't in danger because the company that pays out those earnings generates profits far in excess of the cash sent to shareholders - reach a certain point, investors, whether consciously or not, become much more willing to wait for a stock to start moving upwards. Who cares if your shares only increase from $19 to $20 in a year if you are collecting 7% or 8% in a tax-free account surrounded with a world of 1% bank rates? In effect, you are being paid to wait for things to recover.

Better yet, if the earnings are plowed back into more shares through a dividend reinvestment program (or DRIP as they are sometimes called), the investor is much more likely to generate profits in their portfolio far earlier than they would have if they'd merely bought and held. (For more information on this phenomenon, see Jeremy Siegel's book The Future for Investors: Why the Tried and True Beat the Bold and New.