Definition & Explanation | Formula & Examples | Good & Bad | High & Low | Top 9 Tips
Dividend yield is the return a shareholder expects on the shares of a company in the form of a dividend.
Simply put, the yield represents the “bang for buck” you get back from dividends by comparing them to the share price of a company and measuring:
For example, a company with stock that trades for $10 that paid an annual dividend of $10 per share would have a dividend yield of 100% (= $10 ÷ $10).
This means that the company’s shareholders earned $1 in dividends for every $1 that the stock is worth.
In other words, the stockholders get a 100% return on their investment.
Since, all things being equal, a company with a high dividend yield distributes a substantial part of its profits as dividends, you’d think that higher ratio = more desirable shares, right?
Well, not quite. It’s not that simple. Keep reading to find out the full story >>>
When you invest in shares of a company, you can earn a return from both the dividend yield and capital growth.
Hence, shareholders are concerned with the amount of cash flows, in present value terms, which they will receive from their investment in shares as a result of:
This makes the dividend yield is a key aspect of a share’s performance.
Naturally, a higher dividend yield is more relevant and attractive to income investors who prioritize dividend payouts and want to generate a steady dividend income over the long-term.
In addition, the stock market views strong dividend yields as a positive signal regarding the financial health of the company, including:
For example, well-established mature companies in well-established mature industries (like utilities or consumer essentials) are known to pay out consistent dividends.
Historically, companies that pay dividends mostly continue to do so as a dividend cut is received adversely by the markets.
Consequently, investment in shares of companies with healthy dividend yields is arguably less risky compared to less-established and lower-yield companies.
However, not all corporations choose to pay dividends regularly–or at all.
While some companies distribute a portion of their earnings as dividends, others retain and reinvest all profits into the business.
Why would they do that? Keep reading to find out!
But first, let’s find out how to calculate a dividend yield. >>>
The formula used to calculate the dividend yield ratio is as follows:
Dividend per share (DPS) is a company’s total annual or annualized cash dividend payment, divided by the total number of shares outstanding.
Companies tend to report their dividends as gross dividends distributed. In that case, divide the total gross dividend amount by the number of shares outstanding during that year. As needed, the number of shares can be calculated as a sum total, simple average or weighted average.
The dividend per share is often reported in the financial statements of a company.
Alternatively, the DPS can be calculated in 3 ways:
1. Annual: Total dividends paid during the most recent full fiscal or financial year.
2. Trailing: Total dividends paid over a certain period of time, such as the prior 12 months or the last 4 quarters, regardless of whether these time-periods fall under the same fiscal/financial year or not.
3. Annualized: The latest dividend payment annualized for a full year by multiplying the amount of a single payment by the number of payments per year (e.g., 4 for quarterly dividends, 2 for semi-annual dividend, 12 for monthly dividends)
There are advantages and disadvantages associated with each method of dividend yield calculation.
Price per share reflects a stock’s market value, which is typically the current share price of a company or the open stock exchange price as of the last day of a prior period, usually a quarter/year.
There are a number of alternative dividend yield calculations, including:
Suppose that Company A’s stock is trading at $500, whereas the current share price of Company B is at $100.
Last year, Company A distributed a total annual dividend of $250,000 to 1,000 of its ordinary common shareholders. At $500,000, Company B’s total annual dividend was twice as generous, but it was divided among 5,000 stockholders.
Let’s calculate the dividend yield for both companies.
|Example: Dividend Yield Ratio Calculation|
|Company Financials||Company A||Company B|
|Cash dividend declared and paid during the year||$250,000||$500,000|
|Number of ordinary common shares outstanding during the year||1,000||5,000|
|Current market value per share||$500||$100|
|Dividend per Share (DPS)||$250,000 ÷ 1,000 = $250||$500,000 ÷ 5,000 = $100|
|Dividend Yield ratio (= DPS ÷ Share Price)||($250 ÷ $500) * 100 = 50%||($100 ÷ $100) * 100 = 100%|
Company A’s dividend yield is 50%, while Company B’s ratio is twice as high at 100%.
But what does it really mean for investors?
Simply put, for every $1.00 invested in Company A and Company B, their stockholders received $0.50 and $1.00 respectively.
This results in a 50% and 100% ROI (return on investment) for the respective shareholders.
In other words, if you own or buy Company A’s stock, you would receive a 100% dividend yield on its current share price.
Therefore, all things being equal, Company B would be more attractive to investors interested in dividend income, because it reported a double the dividend yield of Company A.
Investors can be classified into 2 main categories:
|Investor Category||Investor Preference|
|Income-oriented investors:||Prefer to invest into mature and risk-averse companies with relatively high and stable “income stocks”, expecting returns in the form of dividend income.|
|Growth-oriented investors:||Prefer to invest into high-growth companies with “growth stocks” that generate returns in the form of capital appreciation as a result of business development and growth.|
For instance, some stockholders, such as retirees, may be heavily reliant on dividend income for their regular living expenses. On the other end of the spectrum is the “high-risk <> high-return” investment strategy.
As a result, income investors are looking for higher dividend yields, whereas growth investors are satisfied with ratios that are low or even non-existent.
|Good Dividend Yield vs. Investor Priorities|
|Priority||Income Investor||Growth Investor|
There is no such thing as “good” or “bad” dividend yield. Instead, investors use the ratio to find stocks best align with their investment strategy.
Nevertheless, a high dividend yield does not always translate into a high potential investment opportunity, because:
High dividend yields may come at the expense of business growth potential. Every dollar a company distributes to shareholders is a dollar that it cannot reinvest into itself to generate further capital gains.
Similarly, while high yields may appear attractive, shareholders could potentially earn an even higher return if the value of their stock increases as a result of company growth.
As a result, reconciling dividend distribution with earnings retention is a careful balancing act for many companies.
Additionally, a high dividend yield may be a sign of financial distress and unsustainable dividend levels. In other words, if a yield seems to good to be true, it probably is.
Essentially, a company with a high dividend yield could be a good investment, but only if its other financial and business fundamentals are sound.
|High/Low Dividend Yield: Good or Bad?|
|Dividend Yield||Interpretation Examples|
|High||Good: Company retains a large proportion of profits to reinvest into growth projects, promising future capital appreciation.|
|Bad: Company simply cannot afford to pay out a dividend due to low/no profits.|
|Low||Good: Well-established mature company that is slow-growing but rewards shareholders with reliable dividend payments in the long-term.|
|Bad: Risky company trying to spur investor interest with unreasonably high short-term dividend payout–for example, in a desperate attempt to raise equity funds when retained earnings and debt are insufficient or unavailable.|
That is why savvy investors investigate the reasons behind a dividend yield that appears (too) high and assess the company overall when considering a stock purchase.
Keep reading for my top tips on how to do just that >>>
There is little point in evaluating the dividend yield on its own, in isolation.
Instead, here are the 9 most important considerations to help you analyze the ratio in context:
Since the equation is dependent on both dividend value and share price, a dividend yield ratio rises when a company increases its dividends and/or its share price falls–and vice versa.
In other words, the dividend yield is sensitive to fluctuations in stock price, which can be unexpected and dramatic.
|Dividend Yield Ratio: Dividend Value vs. Share Price|
|Dividend Yield||Dividend||Share Price|
In fact, this so-called “value trap” is one of the most common reasons why a high dividend yield does not always indicate an attractive investment opportunity. Quite the opposite, it could be a sign that a company is in distress.
As an example, let’s say that a Company ABC reports a dividend-per-share of $5. The original per-share market price of Company ABC was $50, but it has now fallen down to $25.
As a result, the dividend yield of Company ABC has now doubled from 10% to 20%.
Although the yield of Company ABC may now appear more attractive to dividend income investors, it could be a “value trap” if the reason behind the sharp decrease in stock price is that the company is experiencing a decline.
Eventually, this could lead to the company reducing–or even eliminating–its dividend payments in the future.
The level of dividend yield also depends on the business life cycle of the company in question.
Generally, well-established mature companies are more likely to have higher and more consistent dividend yields than younger growth-oriented businesses.
This is often due to their relatively limited growth potential, where it makes more sense to distribute high portion of net income to shareholders rather than just letting it sit in the bank account.
For instance, there is a group of S&P 500 companies that have increased their dividends for at least 25 consecutive years, called “Dividend Aristocrats”.
Conversely, a fast-growing company may decide to pay out lower or no dividends in the favor of reinvesting earnings into its business for growth.
|Dividend Yield vs. Company Maturity|
|Growth Potential||Low (mature)||High (growth-oriented)|
In addition, the comparison of dividend yield ratios should be done for companies operating in the same industry, because the average yields vary significantly between industry sectors.
Companies in mature, stable and non-cyclical industries with steady dependable cash flows and demand that is not affected by seasonal changes tend to pay the highest average dividend yields, including consumer staple services and products like:
Also, some regulated industries show above-average dividend yields. In the United States, examples include the real estate investment trusts (REITs), master limited partnerships (MLPs), and business development companies (BDCs). Since these entities are required to distribute a significant portion of their earnings in the form of dividends to shareholders, they report high dividend yields as a result.
In contrast, volatile, fast-moving and high-growth industries like technology and electronics typically report negligible or non-existent dividend yields. Here, investors are looking for value growth as opposed to stable dividend income.
Even the best performing company operating in a declining industry will find it more difficult to maintain–not to mention increase–its dividend levels, compared to an expanding industry with soaring customer demand.
|Dividend Yield vs. Industry|
|Growth||Slow (mature or declining)||Fast (growing)|
|Cyclicality||Low (non-cyclical, stable)||High (seasonal, cyclical, volatile)|
One important factor in the dividend yield analysis that could easily get overlooked–even though it significantly affects the performance of the company and its industry–is the macroeconomic environment, such as government regulations, taxation as well as the stage of the economic cycle (e.g. economic recession versus boom).
For example, a company could reduce or halt its dividend distribution during challenging economic times.
Similarly, there may be various tax implications associated with trading with stocks and receiving dividends.
It (literally) pays off to verify dividend yield data that you can find on popular financial websites, because it may be misleading, for instance:
The dividend yield ratio should also be compared to a company’s own historical data to determine its track-record of maintaining or raising dividends.
Investors may not view dividend policy that is erratic or worsening over time as a reliable investment opportunity.
For instance, the stock market generally does not look kindly on dividend cuts and punishes them with a drop in share price.
Consequently, companies that have historically consistently made dividend payments can be reasonably expected to continue to do so–unless something significantly changes in their internal or external environment.
However, that is not true 100% time. Dividend payouts can grow, stagnate, decline, or disappear–in spite of a thorough analysis of historical trends.
It is equally as important to verify that the company has the underlying financial strength to continue paying dividends well into the future.
For that purpose, get an understanding of a company’s historical performance and outlook in the following areas:
Dividends are only one component of a stock’s total rate of return, the other being changes in the share price, which an investor will also benefit from.
As it says on the tin, the Total Shareholder Return (TSR) is a measure that better represents the total return to an investor, because it takes into account both parts of the equation–the dividend yield as well as the anticipated capital growth.
Suppose that you hold a $100 share of stock, which paid $10 in dividends and increased by $10 in value over the last year. As a result, in addition to the 10% dividend yield, you gained 10% in capital appreciation last year. So, amounts to a Total Shareholder Return (TSR) of 20%.
Investors compare the dividend yield to the yields available on other investment options.
For example, the total return on shares (TSR = dividends + capital gains) should ideally exceed the return from fixed interest securities (e.g., interest yield on debentures or loan stock) over the long run.
If the dividend yield is lower than the interest yield, shareholders may expect share price rises. Hence, the lower the dividend yield, the more the market might be expecting future growth in share price, and vice versa.
This all goes to show that the dividend yield is only one of a myriad of indicators that experienced investors and analysts take into account before purchasing stock.
Hence, it is absolutely vital to evaluate the ratio in context and in combination with other financial metrics and non-financial considerations.
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