What are Undervalued Dividend Stocks

A common way to find undervalued dividend stocks is to look at the five year average dividend yield, then find stocks that are currently trading low enough to push the dividend yield above the five year average.

Assume the five year average yield is 9%. At $5.00, with 60 cents per share annual dividend, this stock would be undervalued since its yield is above its five year average. If the price rose to $6.00, the yield would be 10%, still above the five year average. Once the price rose to $6.60 the yield would be .6 / 6.60 = 9% and this stock wouldn’t be undervalued.

Why Prices on These Stocks Go Up

Investors like undervalued dividend stocks because they get a good yield on their investment, with the potential for capital gain. As they start buying, the price starts to rise. This attracts the attention of momentum investors who jump aboard when they see the price “taking off”, which also contributes to the rise in the price. Eventually, after the price rises high enough, the yield has declined to the point where it goes below the five year average. Sometimes the run up in prices is extended if the company continues to increase its dividend, but few companies are able to do that.

What Goes Up Must Come Down

Once the price goes so high that the dividend yield drops below the five year average. The stock has now become overvalued. New buying will slow. The momentum investors will start selling once momentum stops. The dividend yield investors each have to make their decision on whether to cash out or stay, but the majority will cash out since their rational for buying the stock has gone. All this selling will, of course, bring the price down.