Key Takeaways:
- Dividend yield is a financial ratio that shows the relationship between the annual payment on dividend stocks and the stock price.
- This indicator helps to assess the relative attractiveness of investments in dividend income compared to other financial instruments
- The dividend yield does not reflect the true value of a stock. It may increase as a result of a fall in the current share price rather than as a result of growth in the company’s earnings.
In this article we will explain what dividend yield is, provide the formula of dividend–price ratio and give examples of calculations.
Table of Contents
Understanding Dividends
Dividends are cash payments received by shareholders. They represent a share of the company’s profits. The amount is recommended by the company’s board of directors in accordance with the dividend policy. This document and the history of past payments can provide insight into the financial health of the business and its plans for future growth.
Quarterly dividends are usually paid by mature corporations that generate consistent earnings. Young companies prefer reinvestment of the entire income stream into business growth.
Dividends paid in cash are taxable. To optimize tax, many investors favour growth companies or use tax-deferred accounts.
How to Calculate Dividend Yield
Let’s look at “how is dividend yield calculated”. It is the ratio of the annual dividend to the current stock price, expressed in percentage terms. The dividend yield formula is as follows:
This indicator shows the annual yield to make it easier for investors to compare stocks with other sources of passive income. Therefore, the key challenge in the calculation is determining the numerator. Some companies pay a quarterly dividend or monthly dividend. Others distribute profits to shareholders on an irregular schedule.
There are two answers to the question of how to calculate dividend yield. The first is to find the trailing dividend. In this case, the numerator is determined as the sum of all payments over the last 12 months from the calculation date. The second is to calculate the expected future dividend. This is done by multiplying the amount of the last payment by the number of payments per year.
Note! Unlike the formula for return on annual investment, the dividend yield formula does not take into account reinvestment.
Practical Example of Dividend Yield Calculation
As you can see from the answer to the question what is dividend yield, the stock trading price has a significant impact on this indicator. Suppose Company A’s stock price is $50. The annual dividend per share is $5. Then the dividend yield will be 10% ($5 × 100% / $50).
For Company B, with the same amount of annual dividends, the current share price is $100. In this case, its dividend yield is 5%. An investor seeking supplement income is more likely to prefer Company A. However, this decision could be wrong. Before buying, it is necessary to study the reasons that led to the high dividend yield.
Let’s look at “how does dividend yield work” using a real example. Using the dividend yield formula, we find Microsoft’s indicator. The forward annual dividend per share is $3.32. The current share price is $357.86. The desired value is 0.93% ($3.32 × 100% / $357.86).
Dividend Yield vs. Dividend Payout Ratio
Dividend yield indicates the simple rate of return that cash dividends will provide in the event of purchasing a stock. This indicator is needed for a quick comparison of different types of assets and the cash flow they generate. It allows assessing potential return but not its sustainability.
The payout ratio shows the percentage of net earnings that the company directs to shareholders. The formula for this indicator is the ratio of the dollar amount to the company’s earnings. It is not affected by the current stock price.
This indicator allows drawing conclusions about the financial health of the company. It also indirectly indicates the sustainability of future payments. A value above 70%–75% is considered high. It indicates limited possibilities for dividend growth and a risk of reduction.
A low payout ratio shows that the company has enough free cash flow to invest in its development. This increases the likelihood of capitalization growth and future payments to shareholders.
However, a low payout ratio can also indicate that the company’s board is not interested in paying dividends to minority shareholders. In this case, despite the financial health of the business, there is also a risk of dividend suspension. The optimal value is considered to be in the range from 30% to 60%.
Is a High Dividend Yield Good for Investors?
A high dividend yield today is no guarantee of steady income in the future. A rapid increase in this indicator can be a negative sign. It indicates a sharp decline in market capitalization. This may be due to problems with the company’s financial health.
From the definition of “what does dividend yield mean”, it is clear that this indicator does not guarantee compounding returns. Even with the sustainability of rewards to shareholders, there are risks of a declining stock price. This can happen, for example, as a result of rising interest rates and the attractiveness of risk-free assets.
Stocks with high dividend yields can be attractive to yield-oriented investors, such as those who are in retirement.
Value investors, when selecting stocks, should consider many factors. The key ones are:
- dividend payout ratio;
- current ratio;
- a long track record of rewarding shareholders.
These indicators make it possible to assess the underlying financial strength of the company and its ability to regularly pay and increase dividends.
Beware: High-Yield Dividend Stocks Can Be a Trap!
High yield dividend stocks can turn out to be a value trap. Often, a distressed company shows an attractive dividend yield as a result of a declining stock price. A vivid example is the rise in yield of builders amid the subprime mortgage mess during the financial crisis of 2008-2009.
If the reason for the high dividend yield is a downtrend in the stock, there is a likelihood of dividend cuts in the future. If the company tries to maintain them, cash flow will not be sufficient to cover expenses of growth. In this case, investors will not receive capital gains from an increase in the market stock price.
To avoid losses caused by erroneous information, investors need to choose reliable payers. Advisors recommend limiting themselves to companies with a dividend payment history of at least 20 years. At the same time, it is necessary to look for steadily increasing dividends.
Companies with a high current ratio and a low dividend payout ratio can form a reliable source of cash flow.
REITs, MLPs, and BDCs
Unusual yields exceeding average levels are often offered by REITs (Real Estate Investment Trusts), MLPs (Master Limited Partnerships), and BDCs (Business Development Companies). These are specialized investment structures that offer advantages in terms of taxation. They do not pay corporate income tax. The tax burden is fully passed on to the investor.
Each has its own characteristics. For example, distributions from MLPs are primarily a return of capital. This means they can defer taxes until the year the asset is sold. However, they are not suitable for tax-advantaged accounts such as IRAs.
The payments are considered ordinary dividends and cannot be recognized as qualified dividends. The tax rate on ordinary income is higher than on capital gains. The pass-through process of shifting the tax burden to the investor reduces their overall return.
Therefore, investing in REITs, for example, is advisable in tax-deferred accounts such as 401(k) plans.
Dividend-Friendly Industries
There are dividend-friendly industries, including:
- the utility industry;
- the consumer staple industry;
- REITs and MLPs;
- telecommunications, and others.
The best industries for dividends are typically home to mature companies. These companies have minimal opportunities for further market expansion.
Advantages and Disadvantages of Dividend Yields
The advantages and disadvantages of dividends are analysed below. These benefits and drawbacks should be taken into account when developing an investment strategy.
Advantages of Dividend Yields
Dividends make a significant contribution to the total returns of the S&P 500. Reinvestment increases the effect of compound returns. This increases the investor’s capital and their overall income.
The stability of dividends indicates the financial health of the company. It demonstrates management confidence in the future of the business. This, in turn, boosts shareholder confidence.
In retirement, dividends can serve as a source of steady income, paid quarterly or monthly. However, this statement is true only for reliable payers (dividend aristocrats and kings).
Disadvantages of Dividend Yields
High dividend yields are often the result of a declining stock price. They provide erroneous information about the investment attractiveness of a distressed company. A downtrend may indicate problems in the business, which calls into question the sustainability of dividend payments in the future.
Even successful companies face risks of slashed dividends or eliminated dividends. This can be caused by changes in the macroeconomic environment or by issues within a specific industry, such as rising interest rates.
Another drawback is the slowdown in business development. The company has no free cash left to cover expenses of growth. Capital gains from an increase in the value of dividend stocks are unlikely to compare with the results of growth technology companies.
The final disadvantage is an increased tax burden. Receiving regular payments leads to regular tax payments. If you invest in growth stocks without dividends, you only have to pay tax in the year you sell the shares.
Tax Considerations of Dividends
The tax treatment has a significant impact on net take-home proceeds. Most stocks of American companies, index funds, and ETFs pay distributions that can be divided into two tax brackets:
- qualified dividends – taxed at the capital gains tax rate;
- non-qualified dividends – taxed at the ordinary income tax rate.
Tax-efficient investments include tax-advantaged accounts (such as HSAs) and retirement vehicles (IRAs, 401(k)s). Another way to reduce the tax burden is through tax-loss harvesting.
Another issue is foreign investments. Here, there is a risk of double taxation. It is therefore advisable to choose companies from countries with which a treaty has been signed. Another way to save is through the Foreign Tax Credit.
Dividend Yields and Inflation
Dividend stocks are often seen as a hedge against inflation. A regular income stream can help in times of rising prices. However, this only applies to companies that consistently increase their payouts. Thanks to the growth of passive income, an investor’s purchasing power is maintained despite inflation.
But unfavorable situations are also possible. For example, during the 2020 crisis, strong inflation was observed due to government stimulus. Many companies were unable to increase dividends or even cut them. This has eroded the purchasing power of passive income shareholders.
Key Lessons on Dividend Yields
The answer to the question “what is dividend yield” is that it is a forecast of the annualized return on the invested dollar. However, a more important factor is considered to be the stability of the payments.
Stocks with a 10% dividend yield are risky in terms of dividend cuts. Often, such a result is due to dividing legacy dividends by a sharply fallen current stock price. The highest-yielding dividend aristocrats and kings provide no more than 7%–8%.
A 3% dividend yield or less is considered low. Such stocks are usually added to a portfolio with the expectation of significant growth in stock price rather than for passive income.
To assess the underlying financial strength and financial health of a company, one should consider the dividend payout ratio and the current ratio.
As a result of distributing profits among shareholders, the company may lack funds for investing in growth and new projects. Therefore, a high dividend payout ratio indicates low safety and signals the risk of dividend cuts.
Bottom Line
Understanding dividends and their contribution to total returns is important when developing an investment strategy.Income-focused investors should pay attention not only to the size of the dividend yield but also to the sustainability of payments, long-term growth of their amount, the financial health of the business, and their own tax treatment.
The main practical application of the dividend yield metric is the comparison of potential passive income from different assets. However, it is incorrect to evaluate stocks based on a single financial ratio.
FAQ
Is a dividend yield of 3% good?
Yes, this figure is almost twice the average dividend–price ratio of the S&P 500. But some companies pay 5% and higher.
What is meant by dividend yield?
It is the ratio of the amount a company pays per share annually to the current stock price.
What is the difference between annual dividend and dividend yield?
The annual dividend is an absolute value. It shows the amount a shareholder receives in cash. Dividend yield is a relative value. It shows the percentage of invested capital that an investor will receive, considering the current share price.
Is a dividend yield of 5% good?
Yes, this is a fairly good one. At the same time, companies’ stocks with such yields can be found in the lists of dividend aristocrats and kings.
Article Sources
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