Earlier we looked at the RQ (Risk/Quality) ratings of individual stocks. This was a good start to help us understand the risk profile of a stock, and our dividend stock portfolio, but it didn't quite go far enough. Since then I have continued to measure, calculate and calibrate a more comprehensive measure of risk. I sill use the RQ rating as 50% of the new measure, but I have added these two important indicators of risk:
I. Current Price vs. Calculated Price (P)
As part of my quantitative analysis, I calculate a "Buy Below" price. In short, this price is the lower of 1.) the Mid-2 Fair Value or 2.) price needed to generate an acceptable NPV MMA Differential. If the current price is less than plus or minus 10% of the calculated price then this portion of the calculation is assigned a value of 1 (low risk). A difference between plus or minus 10% but less than 20% is assigned a value 2 (medium risk), while anything plus or minus 20% or greater is assigned a 3 (high risk). The 10% and 20% are purely arbitrary and subject to future calibration.
This portion of the calculation determines if the stock is trading within an expected range based on historical metrics such as P/E and yield. Also considered are its valuations using a Graham number and a discounted cash flow model (DCF).
II. Dividend Yield (Y)
Dividend yield is an indication of market sediment, and often an early warning for a troubled stock. In this portion of the calculation, the current yield is compared to predetermined levels and a risk value is assigned. Currently, I am assigning a 1 (low risk) to yields less than 5%, a 2 (medium risk) to values from 5% to less than 8% and a 3 (high risk) for values 8% and greater. As above, the predetermined levels are purely arbitrary and subject to future calibration.
Some might argue that it is "normal" for certain industries to pay out a higher yield, such as 10%. However, I think that "normal" higher yield could be indicative of the implicit higher risk of that industry. Blue water shipping (ocean going) would be an example of this. Also, certain industries, such as utilities, tend to sustain a higher yield due to their lack of growth opportunities.
RQ Revisted
As noted in Measuring Dividend Stocks Investment Risk Profile, the RQ portion is calculated based on S&P's Qualitative Risk Assessment (R) and Quality Ranking (Q).
If the Qualitative Risk Assessment is A, 1 (low risk) is assigned; if B, 2 (medium risk) is assigned and if C, 3 (high risk) is assigned. For the Quality Ranking, S&P assigns ratings of A+, A, A-, B+, B, B-, C, D and Not Ranked. For this calculation, 1 (low risk) is assigned if the rating is A+, 2 (medium risk) is assigned if the rating is A or A-, everything else is assigned a 3 (high risk).
