Dividend stocks are a great way to create income, but how do we choose which stocks to buy? Both dividend yields and valuation ratios such as Price to Earnings and Price to Book Value are used to determine stock selections, but which matters more?
Dividend yield is basically calculated by taking the annual dividends per share and dividing it by the share price. In general, the higher dividend yield, the ‘cheaper’ the stock and the lower the yield, the more ‘expensive’ the stock is. For retirees, dividend yield can be thought of as rate of income return, similar to fixed deposit and bond interests. So you could compare for example, 4% yield stock to 1% fixed deposit to 3% yield bonds when trying to determine retirement income. The dividend yields on Singapore stock exchange ranges between 0% and 10.47%. The high yields look really attractive, but is simply going after the highest dividend yield stocks the way to go?
Price to Earnings and Price to Book Value Ratio
Price to earnings ratio is calculated by taking the stock price and dividing it by the earnings per share. Price to book value is calculated by the the stock price and dividing it by the book value per share. Both P/E and P/B ratios are generally used as valuation metrics. the lower P/E the cheaper the stock is and vice versa.
The Business Times constructed a 10 year comparison between the STI, Top 20 dividend yield, Top 20 lowest P/E as well as Top 20 lowest P/B. The benchmark STI returned 126% for the last 10 years while the high yielding portfolio returned 378%.
Interestingly, the P/E portfolio returned a higher 787% and the P/B portfolio returned a whopping 6,861%! So while it is fine to chase after dividend yields, valuation still matters. Buying cheap stocks is still the key to generate high returns.