A company's dividend yield and cash flow provide useful cross-checks on the PER.

In the sixth instalment of this value investing series, last issue, we saw how the earnings of a company could be split into two elements: one that appears in the form of cash, which can be used to pay a dividend to shareholders or to reduce a company's indebtedness, and one that appears in the form of other assets, as investment for the future. Combining these two elements, we saw that the price-to-earnings ratio, or PER, provides a useful short-cut for valuing companies, but that it has its limitations and needs to be cross-checked against other valuation measures.

One cross-check is the price-to-book ratio we looked at in issue 200/May 06 and issue 201/Jun 06, and another is the dividend yield. You get this, nice and simply, by taking the annual dividends from a company and dividing by its share price. The idea is that this provides you with a smoothed figure for the cash element of the earnings figure. After all, a company can't go on decreasing or increasing its net debt indefinitely—in the first case shareholders will eventually insist on having their money back and, in the second, the banks will.

Major advantages

The dividend yield has some major advantages: it's very simple and it takes us right back to our fundamental definition of value, which is the present value of cash that we, the investors, can expect to receive. Unlike earnings, dividends are actual cash flows into our very own bank accounts, and bless them for that.

There are, of course, some shortcomings, though, and the first of these is that, unlike the PER, the dividend yield doesn't factor anything in for growth, so we have to do that ourselves. The simplest way is to assume that a stock's dividend yield remains at its current level (on the basis that if investors are prepared to settle for a particular yield from a stock's dividend stream growing at a set rate per year now, then they'll settle for the same yield some time in the future). To keep the dividend yield at the same level, the stock price must grow at the same rate as the dividend. Our total return will therefore equal the dividend yield plus the rate of dividend growth.

Visit The Intelligent Investor for the rest of this article on dividends to find out more on ex dividends.