With interest rates stuck at just 2.5% (and potentially going lower!) while inflation sits at a lofty 3%, investors with a large amount of cash sitting in savings accounts and term deposits are at risk of losing money, from a purchasing power perspective.
It's no wonder then that so many Australians have turned to the share market as an alternative to the lacklustre returns on offer from term deposits. Many blue-chip stocks offer fully franked dividend yields in excess of 5%, over 7% grossed-up, which are tax effective and reliable.
However pursuing a stock solely because it trades on a lofty trailing dividend yield is dangerous. Especially in the current market.
As the S&P/ASX 200 (INDEXASX: XJO) climbs higher, the chances of overpaying for a stock are increasing. Whilst that risk is always present, it's vital investors be prepared for volatility by paying a fair price for stocks.
The intrinsic value of a particular stock will vary from one analyst to another because growth rates and other inputs can sometimes be no more than an educated guess.
That's why I choose to run blue-chip stocks which appear complex, through a number of different valuation models. For companies which I believe are primarily an income stock with modest growth potential, I filter them with a few variations of the dividend discount model (DDM).
Essentially, a DDM, values a stock based on its potential to pay (and grow) its dividends over time. It's a simple analysis and should not be used in isolation but it's an easy way to filter through a large number of stocks.
4 potentially overvalued stocks with 7% dividend yields
According to my basic models Telstra Corporation Ltd (ASX: TLS), Insurance Australia Group Ltd (ASX: IAG), National Australia Bank Ltd (ASX: NAB) and Woodside Petroleum Limited (ASX: WPL) are significantly overvalued, despite boasting grossed-up dividend yields in excess of 7%.
Now, if I owned any of these stocks, I wouldn't be rushing for the exits, but let's just say I'm definitely not a buyer at today's prices.