Sometimes when we look at dividend yields of stocks or other investments and see that it is high, we might say “it looks too good to be true”. What does this statement mean? And what do we mean by “unreasonably high yield”?
This means that the current yield per year is higher than average or is higher when compared to similar investments, and the following:
– We expect that the payout at this level is not sustainable and will be reduced at some point in time, and/or
– We expect the price to decline significantly and remain at such a level to the time of disposition (selling) of the investment.
This would ultimately lead to a capital loss or a great reduction in expected net return.
The current yield is not an accurate reflection of the expected yield that will be received each year. It should only be used as a numeric starting point for your analysis at the time of purchase. Remember that the yield is a result of dividing the expected payout (interest/dividend/rent/etc) per year of an investment by the current market price:
Yield = Payout / Price
Yield does not control the payout or price, its the other way around. Payout and price affect the yield. The market price may fluctuate on a daily basis (depending on type of investment), hence changing the current yield on a daily basis.
Yield is inversely proportional/related to price :
Price increase, Payout unchanged = Yield decrease.
Price decrease, Payout unchanged = Yield increase.
If the expected payout changes, and market price remains the same, the yield also changes. Yield is directly proportional/related to Price :
Payout increase, Price unchanged = Yield increase.
Payout decrease, Price unchanged = Yield decrease.
If any two items change, then you need to look closely at the numbers to determine what happens to the yield. Many times investors just look at the yield & forget to look at the other parts of the picture.
An investor’s net return will depend on the payout over time, and market price at the time of disposition. It is possible that the payout over the years change, hence changing the yield on that payout in a particular year. If the payout does not change, then the initial yield would remain unchanged. If the payout remains unchanged and the market price of the investment itself remains unchanged, then the net return each year will be roughly equal to the yield at the time of purchase (excludes commissions, time value of money, taxes, etc).
Changes in payout and market price affect the net return. Therefore an increase in the payout (increased yield), but decrease in the disposition market price may result in a higher, lower, or unchanged expected net return. It all depends on the numbers.
High and Low Initial Yields
In normal economic environments and business/operating conditions, it is very likely the statement may hold to be true (again there are always exceptions). Analysis of the investment would probably uncover specific business or operating risks related to that investment itself. Those risks would impact the investor’s probability of some investment loss (or reduction of their potential gains) and therefore impact their net return. This would require the investment to have a higher payout. Without the higher payout, investors would likely pass on the investment for something similar but with lower risk. It basically compensates the investor for that risk. Now, when a payout & resulting yield is really high, and analysis uncovers really high risks affecting the investment, it can be said that the yield is unreasonably high. It would not be unreasonable to say that the expected net return would be lower due to circumstances resulting in decreased payout or disposition price (some kind of permanent market price decline occuring due to negative business outcomes). The opposite is also generally true (lower payout for more stable businesses, where expectation of maintaining the payout are good).
Unreasonably Low Market Price Causing Higher Yield
However, these are not normal economic times and far from normal business/operating environments. Analysis of the same investments may not necessarily uncover any additional risks that would a likely or significantly impact the investor’s potential gains. Therefore it might not impact their expected net return. If there are many investors that do not realistically or logically assess the risks associated with the investment, they may start to either panic sell such investments or stay away from purchasing them. It could lead to an unreasonable and significant, but temporary market price decline. With the payout remaining unchanged, such market price declines would cause the yield to increase temporarily.
Reasonably Low Market Price, but Unreasonably High Yield
Similarly, analysis of an investment may uncover new risks that would significantly impact the investor’s potential gains in a negative manner. In addition to panic selling, there would be real risks behind a price decline. The market price decline would result in an increased yield, if the payout remains unchanged. However, the payout may not be sustainable at the current level, thus causing the yield to be unreasonably high.
The important thing to know is how to be able to determine whether the yield is unreasonably high (to compensate for really high risks of investment loss), or just unreasonably low market prices. You need to determine if the payout is sustainable and at a conservative level. The following will help you determine this :
1. Know & understand the business/operating environment of the investment – only then can you understand, properly identify, and realistically assess the impacts of circumstances that would affect the investment’s potential return.
2. Know how to calculate the intrinsic value of a specific investment – How do you know if the market price is low or high, if you don’t know how much an investment is actually worth? You need to always know how much something is really worth, before you can determine if it is reasonably or unreasonably priced by other investors.
3. Be conservative – Make realistic & conservative estimates when calculating your potential return. Factor in the risks of loss and how they might reduce your potential gains. What happens in the worst case scenario? How likely are those scenarios to play out?
4. Keep emotions out of the picture – Let your brain do the thinking. Think logically and rationally without letting your emotions guide your investment decisions.
5. Do your homework – Is the yield unreasonably high or is the market price just unreasonably low? Do your analysis and find out! Don’t just guess! Investment & business decisions should not be made on a unfounded guess.
Feel free to post questions, comments, or topic suggestions.
Thanks & Happy Investing!
The Investment Blogger