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I have a question about determining the cheapness of a stock when dividend yield and PE are telling different stories. Also, from a perspective oa an income investor and a capital gains focused investor. Let's take KO for example in two periods shown in the image below.

KO PE and dividend yield for 2011 and 2020

So, in 2011 the values were: PE = 10 and DY = 2.7%. According to PE the stock is cheap, but according to dividend yield not so much.

Now, lets look at 2020: PE = 21 and DY = 3.7%. According to dividend yield the stock is cheap, but PE is saying it's expensive.

(I guess the reason for the March 2020 values is that in the price dropped, but earnings dropped more, so PE is high, but dividend yield is also pretty high.)

I have three questions:

  1. When was/is the stock cheaper and how do we determine this?
  2. Maybe it's cheap in both cases, but for different audiences. For example, if you're a more capital gains oriented investor the 2011 case might be of more interest to you. On the other hand, if you're an income investor the 2020 situation might look nice. Is this the case here?
  3. For an income oriented investor, would you say that the KO stock is cheap in March 2020?
  • There's something funky about your graph. It shows a PE of about 150 in late 2017. – Bob Baerker Apr 3 at 22:47
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    I would encourage you to think of cheap/expensive stocks in relative terms. Absent comparison to other stocks, similar industry/companies, or index, one runs the risk of losing evaluative objectivity. – WittyID Apr 4 at 0:54
  • BobBaerker: The graph is from macrotrends. If you go to their website it shows that at that time the price stayed the same, while earnings dropped greatly. – evilpascal Apr 4 at 11:39
  • WittyID: I agree, but the comparison here is for a specific stock from a capital gains investor and a income investors point of view in two specific periods. Also, let's say I'm an income investor and we assume that KO will not slash dividend, is a PE of 21 and a dividend yield of 3.7% still a good deal? Everyone is saying how expensive KO stock is, but I'm just wondering from whose perspective. – evilpascal Apr 4 at 11:39
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A P/E ratio of 10 and a dividend yield of 2.7% represents a payout ratio of 27.0%.

A P/E ratio of 21 and a dividend yield of 3.7% represents a payout ratio of 77.7%.

If the P/E ratio of 10 had a payout ratio of 77.7% then that would be a dividend yield of 7.8%.

Basically, the dividend yield, combined with a varying payout ratio, does not indicate a relative stock value but a relative risk of the use of corporate cash.

Other notable fundamentals are the gross margin, net margin, and debt-to-equity ratio. In fact a high debt-to-equity ratio is often combined with a high dividend payout ratio so that the bond buyers know that the bonds can be hedged with a liquid stock.

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  • OK, that's the connection of the PE and dividend yield to the payout ratio. I can see the link to risk, but let's assume the dividend is safe. What about question number 2, i.e. the investor type and their perspective in these two periods? – evilpascal Apr 4 at 11:47
  • One type of growth investor would like the P/E of 10 based on recovery prospects while another type of growth investor would like the P/E of 21 based on current prospects. And current prospects can be found in the gross or net margin. Then income investors can do the same thing but income investors can also compare the current dividend rate to the current 10-year Treasury rate. Now the current market is not a good example as a drop in corporate earnings is widely expected while government stimulus is supporting the market. – S Spring Apr 4 at 13:36
  • You are saying that KO stock is currently much riskier for an income investor because the 3.7% yield is too low for a payout ratio of 77.7%. So, the ideal scenario for an income investor would be high yield and low payout ratio (and good fundamentals of course). Now I just have to find a stable company with a payout ratio of 30% and a yield of 10%, but I guess that has some catch also or doesn't exist. – evilpascal Apr 4 at 18:15
  • Well, an income investor in stocks is also a stock investor and so several fundamentals should be considered because stocks are leveraged to the future. But non-discretionary consumer stocks were recently highly valued because they have less of a boom-and-bust cycle. A computer chip company could have a lower P/E and a higher margin but a worry about a downturn. – S Spring Apr 4 at 22:59
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Don't get caught up in dividend yield. Instead, focus on the earnings yield. Dividend yield hasn't been shown to be helpful after controlling for other factors like earnings yield, value and lower volatility. Check out Table 1 here: https://www.onefpa.org/journal/Pages/Dividend%20Investing%20A%20Value%20Tilt%20in%20Disguise.aspx We're getting into factor investing now, a subject on which an incredible amount has been written. I'm not even going to try and summarize the research as I'm sure there are better sources out there.

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