What Is Dividend Yield?
To understand the dividend yield, we need to start with the definition of a dividend.
A dividend is a payment made by a company to its owners, also known as stockholders or shareholders. Generally, the dividend payment represents a portion of the current year’s net earnings, but sometimes special dividends are paid out, which are funded with retained earnings or large asset sales.
The dividend yield is a financial ratio that measures annual dividends paid by a company relative to the current price of its stock. The number provides an estimate of the amount of dividends you could expect to receive each year if you were to invest one dollar in the stock.
How Is Dividend Yield Calculated?
Generally, a company pays dividends once per quarter, but the frequency of payments can vary. Some companies pay a monthly dividend, while others pay an annual dividend. Some pay no regular dividend at all.
If you’re investing your money with the goal of earning future income, the dividend payment is an important number to consider. The dividend payment for a stock is stated on a per share basis and expressed by the dividends per share (DPS) ratio. This ratio is calculated by taking the total dividends paid out by a company over a period of time and dividing it by the total number of common stock shares held by its stockholders.
Let’s take a look at how this factors into the dividend yield calculation. Consider the following scenario, which is also outlined in the chart:
- ABC Corporation paid quarterly dividends of 0.35, 0.39, 0.42 and 0.47 DPS in 2020.
- For all of 2020, the DPS total is $1.63.
- ABC Corporation’s year-end stock price is reported as $65.00 per share.
Based on the data in this scenario, the dividend yield is calculated as follows:
Dividend Yield = Annual DPS ÷ Stock Price
Dividend Yield = $1.63 ÷ $65.00 = 2.5%
Note: To calculate a stock’s dividend yield, you need to include a full year of dividend payments. For a stock that pays dividends semi-annually, include the DPS data for the latest two semi-annual periods. For a stock that pays dividends quarterly, include the DPS data for the latest four quarters. For a stock that pays dividends monthly, look back 12 months.
Why Is Dividend Yield Important?
Dividends are an important source of income for some equity investors, just as interest income is important to bond investors. While everyone likes investment income, a steady stream of income is especially important to retirees, who often rely on the extra cash flow to live.
If your personal finance plan includes equity investments, the dividend yield can provide an estimate of the income you can expect to receive from the money you invest in equities. This knowledge is valuable for planning purposes and can help you make informed decisions about where to invest your savings.
What Is a Good Dividend Yield?
Before we try to pinpoint a good range for a dividend yield, it’s important to note that a stock’s dividend yield can change over time due to financial decisions within a company and also macroeconomic conditions (i.e., changes in inflation expectations, interest rates and productivity growth rates).
Generally, well-established companies will pay higher dividends than early-stage companies. Mature companies tend to have more stable, predictable earnings and fewer investment opportunities than growth-oriented start-ups, a trend which we often see in the technology and healthcare sectors. As a result, established companies usually return more cash to their stockholders in the form of dividends.
Today, the highest-yielding stocks have dividend yields ranging from about 3.0 percent to 7.5 percent, depending on the industry. Across all industries globally, the average dividend yield is about 1.6 percent. Within the United States, the average is a little lower, at 1.2 percent.
Can a Dividend Yield be Too High?
Dividends are just one aspect of a stock’s worth. Oftentimes, the potential for stock price appreciation is a much larger determinant of value.
Before investing in a stock, be sure to consider its dividend yield as well as its growth potential. Also, be aware that an especially high dividend yield is not always a good thing. Take note of the following scenarios involving high dividend yields:
- High dividend payouts can hurt a company’s growth potential and limit its value. Ultimately, every dollar paid out to stockholders is a dollar that a company is not reinvesting in itself.
- Sometimes, a high dividend yield is the result of a sharp stock price decline, not a hefty dividend. The resulting dividend yield looks good on paper, but it’s misleading and could keep you from looking at the real story — a tanking stock price.
- A high dividend yield could be a trick to attract investors. Dodgy companies use this tactic to lure you in, but their dividend payouts are not sustainable. Many times, the companies themselves are not sustainable.
Note: To get a realistic sense of a company’s dividend yield, track it over time through good and bad market cycles. You should also compare it to the industry norm.
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Dividend Yield vs. Dividend Payout Ratio
To close, let’s take a minute to differentiate between the dividend yield and another commonly used financial ratio — the dividend payout ratio (DPR).
While the dividend yield expresses dividend payments as a percentage of stock price, the DPR expresses dividend payments as a percentage of a company’s net earnings.
The DPR is calculated by taking the dividends per share (DPS) ratio and dividing it by the earnings per share (EPS) ratio. (The EPS ratio is the company’s annual net earnings divided by the number of common stock shares held by stockholders). The formula is below.
DPR = Annual DPS ÷ Annual EPS
Continuing with the ABC Corporation example introduced above, let’s assume the EPS ratio is $4.00. This means the dividend payout ratio is calculated as follows:
DPR = $1.63 ÷ $4.00 = 40.75%
From this calculation, we know ABC Corporation is paying out almost 41 percent of its annual net earnings to stockholders. At its current stock market price of $65.00, this equates to a dividend yield of 2.5 percent.
Note: A stable dividend payout ratio is a good sign for investors. It shows a company is financially sound, with quality earnings and a commitment to pay a consistent dividend to its shareholders. A ratio above 60 percent is rarely sustainable; a ratio above 80 percent is a serious red flag.
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