The Dividend Yield of a stock can be a good indicator when researching the value of a company or when deciding if a company is performing well or not. While it does have it’s place when evaluating cash producing investments it would be foolish to just consider a dividend yield when investing your cold hard cash.
Functions of a Dividend
Intrinsically, dividends are a profit sharing reward by a company for an investor holding a shareholding in that business. Think about a small business owner or farmer, If they make any profits they get to keep these profits as they own the company. Well as a share holder, you are in fact a business owner and a dividend is a form of payment for part owning the company.
Who Will Pay a Dividend
Usually, as discussed in this post, only profitable companies will pay out dividends which is why I believe that companies that have paid out increasing dividends for an extended period of time are “safer” investments. Newer companies are unlikely to pay dividends because they are more than likely going to use their profits to facilitate the future growth of the company which may be good news for growth investors.
Dividend yield is a historical figure
The dividend yield is based on the share price of the company and how much they have paid out in dividend payments. Notice that I am using past tense here, paid and not will pay. As such the dividend yield is a historical figure and should not be treated as a mechanism to predict a companies future dividend policy. Of course their are companies who have a history of paying and increasing dividends each year but at any moment they could stop if they feel necessary.
Dividend Yield calculation
A Dividend yield is a metric by which you can measure how much cash flow you are getting for each euro/dollar you have in a equity position. Ignoring capital gains, the dividend yield is seen as your return on investment for a share or stock as it is a ratio that shows how much a company pays out in dividends relative to its share price. Yields for a current year are often estimated using the previous year’s dividend yield or by taking the latest quarterly yield, multiplying by 4 and dividing by the current share price.
Let’s take two companies who pay a similar cash amount in dividends but have a vastly different dividend yield.
ExxonMobil Corp (XOM) current price is $74.61 and their current quarterly dividend rate is $0.77
$0.77 * 4 = $3.08
( This is the Yearly dividend payment)
$3.08/ $74.61 = 4.13 %
(This is the Dividend Yield)
Becton Dickinson & Co (BDX) current price is $216.70 and their current their current quarterly dividend rate is $0.75 which is only $0.02 lower than XOM however their yield is 1.38%
$0.75 * 4 = $3.00
$3.00/$216.7 = 1.38%
This calculator can help you calculate the dividend yield
Yield is based on the stock price
A low dividend yield, in general, means that their is a high demand from investors. This high demand will drive up the stock price and produce a lower yield with respect to the dividend, while a high dividend yield indicates that a stock is in low demand from investors. It should be quite obvious now, but the stock price is critical when calculating the dividend yield. If a company experiences a dramatic decline in their stock price, the dividend yield will increase providing the dividend payment is kept intact.
For example, using XOM like above with a share price of $74.61 and a dividend yield of 4.13 % based on a dividend of $3.08. If the share price dropped by 50% to $37.30 than assuming the dividend remained the same, the dividend yield would now be 8.25%. While it would be nice to earn an 8% yield on your investment the 50% drop in capital investment would be a significant loss. The same would be true if the share price doubles, the new yield of 2% may not be as attractive but the capital appreciation would be welcome along with receiving the same dividend payout
Risks of high yield stocks
As mentioned above, stocks with a very high yield may be due to a huge decline in the stock price without a change in dividend payment.A huge decline in the market should be a red flag to any investor as this could see a decline is a companies business and profits which could make it difficult to maintain the dividend payouts.
Why yield is important
By using the yield of each stock, it gives a better overview for judging the value of each investment. Simply comparing the dividend payout could be misleading as it ignores the amount of shares that can be bought from a fixed investment.
For example, Imagine company A and company B were paying a dividend of $3.00 each. by simply comparing the payment, it would be hard to access which company offers a better investment. Now what if company A has a share price of $50 giving a dividend yield of 6% while company B has a share price of $100 with a dividend end of 3%. Quite clearly we can now see that we can buy twice as many shares with company A and as a result our dividend payout will be twice as high.
|company A||company B|
|share price||$ 50.00||$ 100.00|
|dividend payout||$ 3.00||$ 3.00|
|no of shares||20||10|
|payments received||$ 60.00||$ 30.00|
The dividend yield is the ability to attain a dividend income with respect to the capital investment and is calculated by dividing the dividend per share by the share price. Although it should not be used as the solo means to investing in a stock, a high dividend yield is important for those who are looking to maximize their cash flow. Typically companies who pay increasing dividends are regarded as being more stable and mature which can be attractive for the lower risk investor.