This is the first part in a series of post where I will explain what I use in my scoring system when seeking stocks to compound my income.
The most obvious place to start is with the dividend yield which is certainly one factor which I use. However, when it comes to picking value stocks more generally this is not necessarily the best way to identify value stocks. Even though yield covers this to to a certain extent as often higher yielding shares tend to offer value as they have got onto a high yield by being beaten up or neglected. I do however like to check other valuation and financial metrics when considering yield shares to ensure that I am buying value and not just an expensive, low quality and financially challenged high yield stock.
Research carried out in the Book Quantitative Value by Gray & Carlisle suggested that the best measure for this was earnings yield or EBIT/EV which is calculated by taking the operating earnings (operating margin x turnover) and dividing this by the Enterprise Value of the company (Market Capitalisation + Net Debt) which better reflects what it would cost to buy the whole company based on its existing financing arrangements. In the book they also examined combining value measures and found that this could also do a good job of identifying value stocks.
Therefore I combine earnings yield and dividend yield or EYDY as a way of scoring the value offered by a stock as I am interested in buying cheap (value) stocks with a decent yield. I do then also look at other measures such as the P/E to get a feel for how expensive a stock is overall.
In Parts 2 and 3 to I will look at how I assess the security of the likely income and the financial security of the stock.