Whether you're looking for dividend-paying stocks for the long term, or you're an investor needing current income, dividend yield can be a helpful tool for analyzing a stock, mutual fund, or ETF. It can also be helpful for investors to know how to calculate dividend yield for themselves.
What Is Dividend Yield?
Dividend yield is a financial ratio that measures the dividend a company pays out to shareholders over the course of a year in relation to its stock price. The dividend yield is expressed as a percentage and it's calculated by dividing the dividend of a stock by its price per share.
A dividend stock distributes a portion of the company's earnings at regular intervals, such as monthly, quarterly, semi-annually, or annually. Dividends, along with interest, capital gains, and distributions realized over a period, are what comprise a stock's total return.
Important: When analyzing dividend stocks, some investors may be seeking high dividend yields while others may be seeking companies with a history of increasing their dividends year over year. Some investors may be looking for stability in the dividend yield over time.
Calculating Dividend Yield
Dividend yield is calculated by dividing the annual dividends paid per share by the stock's price per share. For example, if a company had a trailing twelve-month dividend of $2.50 per share of its stock, and the current price per share is $75.50, the dividend yield would be 3.31%.
2.5 / 75.5 = 0.0331 x 100 = 3.31%
Uses for a Dividend Yield
Analyzing dividend yield is a means of measuring the amount of cash flow an investor may expect to receive from a stock, mutual fund, or ETF. In different words, dividend yield is one of many ways to determine the value of a stock or a fund that invests in stocks.
Investors are wise to keep in mind that a stock's dividend yield is just one component of its total return. For a simplified example, if a stock's price appreciates by 7% in one year, and its dividend yield is 3%, the total annual return for that stock is 10%.
Advantages of Using Dividend Yield
- Identify quality stocks: A company's dividend yield can help to measure the stability of a mature company. A consistent and rising dividend often accompanies consistent and rising earnings per share.
- Simplicity: The dividend yield calculation is quick and easy to calculate. All that's needed to make the calculation is the dividends per share, the price per share, and about five seconds of your time.
- Comparison modeling: Comparing the dividend yield of a company's stock to other companies within the same industry can help when analyzing stocks to consider buying.
Disadvantages of Using Dividend Yield
- Impractical for some types of stocks: When evaluating certain types of stocks, such as small-cap growth stocks, the dividend yield may provide little hint as to whether or not the company is a wise investment. This is because many small companies are not in the financial position to pay a dividend to shareholders.
- Potentially misleading: Stocks with high dividend yields may appear attractive on the surface, but sometimes a high dividend is created by a sharp decline in a stock's price. Companies that experience a drop in their stock price might be facing declining business prospects, which potentially could put the dividend at risk.
- Inconsistent or overly simplistic: While the dividend yield calculation is simple and can help to evaluate the health of a business, an investor is wise to analyze more than just dividend yield. For example, other financial ratios, such as the P/E ratio, price-to-book ratio, and dividend payout ratio, can be important complementary indicators beyond just the dividend yield.
Dividend Yield vs. Dividend Payout Ratio
The dividend yield of a company is its annual dividend by its price per share. However, the dividend payout ratio is calculated by dividing the company's dividend amount by its earnings per share.
Dividend Yield = Annual Dividend Per Share / Price Per Share
Dividend Payout Ratio = Dividend Paid / Earnings Per Share
Some investors use both ratios to measure a company's financial health for determining whether or not its stock is a good value.
What Is a Good Dividend Yield?
What qualifies as a good dividend yield is subjective, but the answer might be a range between a 2% and 6% yield. Qualifying a good dividend often depends upon multiple factors, such as industry, interest rates, market conditions, and business development stage.
It's important for investors to understand that a high dividend yield is not necessarily an indication of a high-quality company or attractive stock, and a low dividend yield is not necessarily indicative of a low-quality company or a poor investment choice.
These factors may influence the appeal of a dividend yield:
- Industry: The dividend yields offered by similar companies within the same industry are important to consider. For example, companies in the utilities, consumer staples, financial services, and real estate sectors would generally be expected to have higher yields than those in the technology and consumer discretionary sectors. The appeal of bank stock may be determined partially by comparing its dividend yield to those of other banks.
- Interest rates: When bond yields are extremely low, a relatively low dividend yield for a stock can be attractive to an investor that needs income from their portfolio. However, if bond yields rise, that same stock dividend may now be less attractive in comparison.
- Market conditions: In poor market conditions, when prices are falling, dividend yields can move higher in the short term directly as a function of lower stock prices.
- Business development stage: Businesses that are in the start-up and early growth stages of business development often use profits from earnings to reinvest in the company, rather than share those profits with shareholders in the form of dividends. Thus, a smaller growth-oriented company would not be as likely to pay dividends as large, mature companies. But that fact doesn't automatically make these small growth companies poorer investment choices.
It's wise for investors to do more than just look for high dividend yields. It's worthwhile to assess why a particular company's dividend is relatively low or high. Generally, a dividend that rises along with rising earnings per share can be an indication of a quality dividend stock. An extremely high dividend yield, or a rising dividend because of a falling stock price, depending upon market conditions, could be cause for investor concern and caution.
Tip: Investors should use caution when looking at stocks that pay the highest dividends. For example, a weak company may be paying high dividends now, but might be at risk of reducing its dividend in the future. If that occurred, the dividend cut could undermine investor confidence and push down the company's stock price.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
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