The Magic of Effective Yield

Dividend investors are familiar with yield. It's that lovely percentage of payout that tells you how much you are receiving from your income investment. And of course the higher yield the better, if the investment is safe enough. As a dividend investor, you probably know the current yield of some or many of the dividend stocks you own. That's good. Always, the more knowledgeable you are about your investments, the better able you are to make informed decisions.

Yet as much as you may see and hear investing information which talks about yield, whether high-yield investments or simply anything about yield, you seldom see or hear much about effective yield. What is it and how can you profit from it?

Stock Price, Payout And Yield

To understand effective yield, let's back track a bit and do a quick review of the most basic workings of dividend stocks. Please bear with this. Stock X sells for $50 a share and pays a $2 dividend. The $2 is called the payout, which is the annual dividend distributed to you, the shareholder, usually in four quarterly equal payments. In this case, the quarterly dividend would be 50 cents.

The yield, or more precisely, the current yield, is the percentage of income the stock pays with its dividend. With a $2 annual dividend on a $50 share of stock, the yield is 4%. This is arrived at by dividing the share price into the dividend, or 50 into 2.00 which gives an answer 0.04 or 4%. Simple enough. Stock X has a 4% current dividend yield.

Dividend Yields Are Elastic

But dividend yields are not actually static, though sometimes investors regard them that way.

Let's suppose that our stock X has a 52-week price range of $45 to $55 per share. With the same dividend, the yield can change. Let's say our stock X, still paying out $2 a share, has had a terrific couple of quarters with its earnings, and that in a buoyant market, its share price rises to $55. Now the current yield has fallen to 3.63%. Conversely, if the market goes sour or perhaps there's unhappy earnings news for stock X and its share price falls to $45, the current yield rises to 4.44%. Same dividend, different share price; something of a different investment.

Why This Is Important

Obviously, for the income investor, buying the stock at a $45 share price can potentially be a better deal. We say potentially, because a lower share price can signal trouble for a company, especially if its fundamentals are not as strong as they were at the $55 or $50 share price. Value investors will recognized this as a value trap. On the other hand, the market may have simply taken stock X's share price down along with others, so the $45 price may be a bargain.

Dividend Increases And Yield Increase

Let's say stock X is doing just fine, and its price variation between $45 and $55 signifies no more than the normal fluctuation in the buying and selling of its shares. If you bought the stock at $50, and it remains or returns to $50 a share, but the company raises the dividend a penny a quarter for a 4cent annual dividend increase, this is a 2% increase, a happy event for shareholders. Now the stock pays $2.04 in annual dividends and yields 4.08%. And so on.

(McDonald's recent dividend payment history)

If the company makes incremental dividend increases and the share price creeps up—even if the stock isn't a particularly high-flyer, as many dividend payers aren't--these increases can add up, particularly for long term investors. If in even a couple of years the dividend increases bring the payout up to $2.25, and you are able to buy shares again at $45 on a market dip, with the underlying fundamental business still sound, your yield on these shares is 5% instead of 4%.

This is a very conservative example of dividend investing. Yet even if you are not a long-term holder, the added payout will make the stock more attractive even if you plan to buy stock X and hang onto it for 3 to 6 months. Perhaps you employ a strategy of buying dividend payers near their 52-week lows and turn them over when their stock price appreciates. The increased dividend payout kicks in some extra cash along with your capital appreciation. There are many ways to win with dividends.

Another Kicker

Now let's say you bought your shares of stock X at $45, held it for a couple of years, and the price rose to $60, then $65. Even at the original annual dividend payout of $2.00 per share, you can see how you're really making out. While other dividend-shoppers see only a 3.08% yield, you would be receiving a 4.44% yield plus capital appreciation of 44% on your original investment. Suppose the dividend had been raised to $2.25. Again, you bought the stock for $45, so you are receiving 5% yield on your original purchase, compared to the 3.46% that a buyer at the current $65 price does. Your 5% is your effective yield, and your capital appreciation is 44%.

Does It Happen In The Real World?

Of course. McDonald's (NYSE: MCD) pays a $2.44 per share annual dividend, which gives a current yield of 3.1% on its recent closing price of $78.70 per share. But had you bought the stock at its 52-week low of $65.31, your effective yield would be 3.74%. Going back even a couple of years, to 2007, if you'd bought McDonald's at $50, although the dividend then was $1.50, you are now receiving $2.44 on your $50 purchase price. That now gives you an effective yield of 4.88% on a payout of $2.44. And so on.

Planning to increase your effective yield by buying stocks at lower prices is just another often overlooked, seemingly simple technique to boost your dividend investing results.

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