Dividend yield is a financial ratio that explains the relationship between how much a company pays out in dividends on an annual basis in relation to the current stock price. Companies pay dividends as a way to reward shareholders and return profits to the rightful owners of the company, which is you if you own shares in the given company. Over time, if the company continues to perform well, investors have the opportunity to received increased dividend payments on an annual basis as profits grow. Increased dividend payouts do not necessarily correlate to higher average dividend yields all the time. Investors can use dividend yield as a valuation tool for those companies that regularly increase their dividend payouts on a regular basis, also known as the dividend yield theory. Let’s take a look at how to calculate dividend yields and why dividend yields matter.
Calculating Dividend Yields
Let’s begin by covering the basics, how to calculate this dividend yield I speak of. Dividend yield is shown as a percentage and can be found on most financial websites. It is calculated by dividing the current annualized dividends paid by the dollar value of one share of stock. Let’s use one of my favorite dividend stocks, Johnson & Johnson (JNJ), as an example to calculate the company’s current dividend yield.
If I wanted to calculate Johnson & Johnson’s dividend yield, I would first need to find out their current annualized dividend payout. It is important to annualize the most recent dividend payment or announcement, if it has been changed, to give you the most precise dividend yield. For this, we can use Seeking Alpha as a tool. Go to the JNJ page within Seeking Alpha, as shown below.
As you can see in the screenshot above, the company currently pays a quarterly dividend of $0.90, which is $3.60 annualized. The current price for a share of JNJ stock is $138.81. If you divide $3.60 by the share price of $138.81 you will calculate a dividend yield of 2.59%.
The dividend yield is often posted for you as well, but is usually not updated until the close of the market, so if there is a big swing in a share price during the day, the dividend yield shown may not be accurate, so it is always important to calculate this on your own.
Why Dividend Yields Matter
It is important to note that a company’s dividend yield can change over time, either due to market volatility or as a result of dividend increases or decreases. Dividend yields are important to most value investors looking for stable income. Dividend yields are important as they represent the amount of cash flow you’re getting back from the company in return for your investment.
Value investors tend to look for stable income or minimum returns from their investments, which they can secure through investments in dividend paying stocks with stable dividend yields. Take note that I said, “stable yields.” Be wary of high yields, as they could be what we call a “sucker yield.”
It is always important to compare the current dividend yield with its recent historic average. I like to use a five-year average myself. Sometimes a higher than usual dividend yield could be the result of the stock plunging. A slumping stock price results in the dividend yield increasing. A good example of this is Altria Group (MO), which saw their stock price plummet over 30% in two months time from November 2018 to January 2019. Investors were fearful of a slowdown in cigarette volumes and the company had made two big investments in cannabis company Cronos (OTC:CRON) and e-cigarette giant JUUL. Investors were fearful that the company had overpaid for their investment in the companies. After doing my research, I agreed with those folks that the company had in fact paid a large premium, but I liked the long-term prospects of the investments more, and with a dividend that is normally in the 4% range, had suddenly jumped to 7.5%. I took advantage of this and fast-forward to today, I am sitting on a solid 20% profit after six weeks of being in the stock. Now, of course it does not always work perfectly like this, so do your due diligence.
It is important for the investor to look into why the company is dropping to see if the dividend is at risk of being cut, which is never a good thing. High yields can be attractive, but one must remember it could come at the cost of growth.
On the other hand, a high-dividend yield does not necessarily mean it’s a sucker yield. It is important to understand the type of stock you are investing or researching, as REITs tend to have higher than normal dividend yields, as they are required to payout 90% of their taxable income to investors to earn their REIT tax status. REITs is a sector I cover heavily here at seeking alpha, so you can look at a few of our past articles for some good investing ideas. However, if you want to learn more basics on what a REIT is and its tax status, look no further than the NAREIT website for further explanation.
Dividend Yield As A Valuation Tool
So far, we have learned what a dividend yield is or represents, then we learned why a dividend yield matters, next let’s turn our focus to how we can use the dividend yield as a valuation tool. The dividend yield theory, or DYT, is something I use for my own personal investing today.
DYT simply compares a stock's yield to its historical norm, because assuming the business model and growth rates haven't changed much, yields are mean reverting and approximate fair value. This approach tends to work for stocks that have consistently grown their dividend over the years. Let’s use our JNJ example again to show you how the DYT works.
Over the last five years, JNJ has had an average dividend yield of 2.63%. As of today, the stock has a dividend yield of 2.59%, which we calculated above. This implies the stock is slightly overvalued by about 3% in regard to recent historical trends.
To learn more about the dividend yield theory, take a look at Simply Safe Dividends website, which he put together a full article explaining the topic in even more detail.
Another way to utilize a company's dividend yield is to compare it within its industry group. Other dividend stocks to compare JNJ to include: AbbVie Inc. (ABBV), Pfizer (PFE), and Merck & Co (MRK) among others. Refer to the "peers" tab to see other JNJ peers.
In conclusion, we have looked at what a dividend yield is and how it is calculated. Ensure you use the most recent quarterly announced dividend annualized to calculate the most accurate dividend yield. Next, we discussed why dividend yields matter. When looking at a dividend yield, be wary of high yields and know the type of company you are researching. Lastly, we showed you how you can utilize dividend yield as a valuation tool by looking at the company’s recent five-year history compared to today’s yield to determine if a stock is under or overvalued. This is just one of many valuation ratios or metrics to utilize when researching a stock.
I hope you found this article useful. Now that you understand what a dividend yield is and why it is important, your next step is looking further into the dividend. Refer to Jussi Askola's article referencing "What Does Dividend Mean" for further dividend information. He covered various topics related to dividend within his piece and is a solid read.
Disclosure: I am/we are long MO. 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.