What Is Dividend Yield?

by: Rida Morwa
Summary

Dividend yield is calculated by dividing the annual dividend per share by the price per share.

Calculating yields within your portfolio can help you better understand how your investments are performing.

It also helps you better take advantage of market mispricing.

What Is Dividend Yield?

When investing our hard-earned money, we want to make sure we are getting the most out of our investments. One of the attractions of stocks that pay a dividend is the regular cash-flow that is dispersed into our investment accounts. It is very important to know how much cash we can expect to receive. Dividend Yield is a percentage of how much cash can be expected to be received from an investment vs. its price per share.

In the investment world, the word “yield” is the ratio of cash received or expected to be received and the dollar value of an investment. Mathematically, yield is calculated as: Annual Dividend/Price Per Share = Dividend Yield.

What Is Current Yield?

For investments in stocks, there are several types of yields commonly referenced. The first, and most common is current dividend yield. It is calculated by estimating the next 12-months of dividends and dividing by the current share-price. If you are looking at a stock chart, this is the percentage you will see that is labeled “yield” or “dividend yield”.

For example, suppose that a stock has an annual dividend rate of $5 and the shares sell for $80. Therefore, when you invest, you expect that each year you will receive $5 from each share of stock you purchase. The yield is $5/$80 = 6.25%. In plain English, a 6.25% dividend yield is telling you that you can expect to receive $6.25 in annual dividends for each $100 you invest.

Knowing this will make it much easier for you to estimate how much you can expect to receive in dividend payments. Suppose you are considering investing $13,500 and want to know how much you will receive in dividends. You can multiply your expected investment by the yield to get $843.75 ($13,500 X 6.25%), that is the amount you can expect to receive each year at the current dividend rate.

Estimating the Dividend

It is important to make sure you are accurately predicting the dividend. In many cases, the dividend can be easily estimated by taking the most recent quarterly dividend payment, multiplying by 4, and then dividing by the current market price. This method is assuming that the dividend payout will remain stable over the next year. Be warned that this is the method most often used by data providers. While generally accurate, it can become very inaccurate if a company has a dividend that is not steady.

Is Dividend History Important?

Make sure you look at the dividend history, some companies are very predictable with stable dividends and any raises come during the same quarter each year. Others might have dividends that vary each quarter or might be on a different dividend schedule such as annual, semi-annual or monthly. To determine the current yield, you want to make sure you make every effort to accurately predict the next 12 months. If the dividend varies quite a bit, looking at the last 12-months or consulting management guidance might prove more accurate than annualizing the most recent payment.

https://static.seekingalpha.com/uploads/2019/2/10/47745229-15498282736472435.png

Source: Seeking Alpha

Consider this dividend history for Newtek Business Services (NEWT), a dividend growth stock that we are currently recommending to our members of High Dividend Opportunities. As you can see they tend to reduce their dividend from Q4 to Q1 and then raise it as the year goes on. Annualizing the Q1 dividend would underestimate the dividend, while annualizing the Q4 dividend would overestimate it. Most websites are reporting that NEWT pays a dividend of $2.00/year and base their yield calculations on using that number. However, management is forecasting the 2019 dividend will be $1.84.

At the current price of $19.33, most financial sites display the dividend yield as 10.35%. Doing the calculation using management’s guidance we would take $1.84 and divide by $19.33 to arrive at 9.52%. That is why it is crucial that you take the time to understand how yield is calculated and take the step to calculate it yourself rather than rely on data aggregators.

Changing Yield

Since the equation to calculate yield has two variables, annual dividend and price per share, changes in either of those numbers is going to impact the yield.

Investors are often advised not to “chase yield”. This advice is offered because yield alone is not a good measure of how successful an investment will be. When yield is abnormally high, it is an indication that the price has gone down significantly. Often, it is the fear that the dividend might be cut that will drive prices down and result in very large yields. This is because, in anticipating the dividend cut, many investors have sold their shares and pushed the price quite low. While a low share price might represent a good opportunity, it can also represent the market’s judgement that there is a lot of risk with the company.

If you are performing due diligence on a company and see that its yield is much higher than their historical yield, and/or than their peers, that could be a warning sign. It is telling you that the market believes the company is at a higher risk of further price drops or cutting the dividend. Some of the best opportunities occur when the market is convinced a dividend cut is likely, but the dividend is maintained.

By the same token, low current yields don’t mean that a stock is safe. Just like the market might overestimate the risk to one company, it might underestimate the risk of another company. Yield by itself doesn’t paint a complete picture. You need to understand if the company can continue to pay the dividend, and why the market is pricing the stock at the current level. Yield can be useful for screening stocks or providing an estimate of current market sentiment towards a company, but it is not a replacement for due diligence.

Other Yields

Many investors like to use various measures of yield to judge or compare their performance. When you understand that yield is essentially a ratio of an amount received divided by the amount invested, you can calculate a number of different types of yield. Above, we focused on “dividend yield”, where the amount received is unsurprisingly the dividend. Interest yield is essentially the same thing except the amount received is interest instead of dividends.

A common yield metric you might see in comment sections is called yield on cost (YoC). This is calculated by dividing the current annual dividend by the price paid to obtain the investment. In this case, the amount received remains the dividend, but instead of dividing by the current price, you divide by the price when the shares were acquired. Unlike current yield, the market price of the shares has no impact. Instead, the YoC is going to change as the company raises or lowers its dividend, or when new shares are bought changing the average price paid per share. Whole articles have been written on how (or how not) to use this metric to evaluate the performance of an investment.

You can also calculate yields for your whole portfolio. You just take the total annual dividends for your portfolio and then divide that by the current market value of your portfolio to get the current yield of your portfolio. You can also determine yield on cost for the portfolio by dividing the total annual dividend for all the positions by the cost of the portfolio (a value your broker often tracks for you).

Final Thoughts

Yield is a simple ratio of cash flow and share price. Dividend yield is a measure of how much the company is paying shareholders, relative to the current share price. Dividend yield is one way to compare investments in different securities. For investors who are seeking to receive a certain amount of cash-flow from their investments, it is crucial to understand how to accurately estimate dividend yield.

Using a stock screening tool, yield can be a useful metric for narrowing down which companies you wish to investigate further. However, yield on its own is not a substitute for due diligence. A high dividend yield can indicate troubles, or it can indicate a great opportunity to buy at a low price. A low dividend could indicate safety, or it could indicate that shares are overpriced.

Calculating yield within your portfolio, or sections of your portfolio can help you with your investment planning. It will help you better understand how much of your return is coming in cash. For retirees or others who wish to withdraw a certain amount of cash from their portfolio each year, targeting a high enough dividend yield can help provide enough cash flow without having to sell investments.

If you're interested in finding dividend investment ideas and strategies, you can visit Seeking Alpha's Dividend page.

Disclosure: I am/we are long NEWT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.