What is dividend yield?
Dividend yield is the ratio of a company’s annual dividend to its share price. The dividend yield is represented as a percentage and is calculated as follows:
Dividend yield = Share PriceAnnual DividendTheThe
Depending on the source, the annual dividend used in the calculation could be the total dividends paid during the last financial year, the total dividends paid during the last four quarters or the last dividend multiplied by four. As an alternative to calculate the dividend yield, you can use the dividend yield calculator from Investopedia.
Introduction to dividend yields
Key points to remember
- Dividend yield is the amount of money a company pays to shareholders (over the course of a year) for owning a share of its shares divided by its current price, displayed as a percentage.
- The dividend yield is the estimated one-year yield from an investment in a share based solely on the payment of the dividend. Note that many stocks do not pay dividends.
- Mature companies tend to pay dividends, with companies in the utilities and consumer staples often paying higher dividend yields.
- Real estate investment trusts (REITs), master limited partnerships (MLP) and business development companies (BDC) pay above-average dividends, but dividends from these companies are taxed at a higher rate.
- Higher dividend yields are not always attractive investment opportunities, as its dividend yield may be high due to a fall in the share price.
Understanding the dividend yield
The dividend yield is an estimate of the dividend yield only of an investment in shares. Assuming that the dividend is not raised or lowered, the return will increase when the stock price drops and fall when the stock price increases. Because dividend yields change with stock prices, it often seems unusually high for rapidly falling stocks.
Since the dividend itself is rarely changed, the dividend yield will increase when the stock price goes down and decrease when the stock price goes up. Certain stock market sectors, such as non-cyclical consumption or public services, will pay an above-average dividend. Newer smaller companies that continue to grow rapidly pay a lower average dividend than mature companies in the same industries.
In general, mature companies that do not grow very quickly pay the highest dividend yields. Non-cyclical consumer stocks that market basic items or utilities are examples of entire sectors that pay the highest average return.
Although the dividend yield among technology stocks is below average, the rule for mature companies also applies to a sector like this. For example, in November 2019, Qualcomm Incorporated (QCOM), an established telecommunications equipment manufacturer, paid a dividend with a return of 2.74%. Meanwhile, Square, Inc. (SQ), a new mobile payment processor, paid no dividends.
The dividend yield may not tell you much about the type of dividend the company pays. For example, the average dividend yield in the market is the highest among real estate investment trusts (REITs) such as public storage (PSA). However, these are the ordinary dividend yields, which are a little different from the most common qualified dividends.
In addition to REITs, Master Limited Partnerships (MLPs) and Business Development Corporations (BDCs) also have very high dividend yields. These companies are all structured in such a way that the US Treasury forces them to pass on most of their income to their shareholders. The pass-through process means that the business does not have to pay tax on distributed profits as a dividend, but the shareholder must treat the payment as “ordinary” income on their taxes. These dividends are not “eligible” for the tax treatment of capital gains.
The higher tax liability on ordinary dividends decreases the effective return earned by the investor. However, after adjusting for taxes, REITs, MLPs and BDCs continue to pay dividends with above-average returns.
Advantages and disadvantages of dividend yields
Historical data suggests that a focus on dividends can amplify returns rather than slow them down. For example, according to analysts at Hartford Funds, since 1960 more than 82% of the S&P 500’s total returns have come from dividends. This is true because it assumes that investors will reinvest their dividends in the S&P 500, which increases their ability to earn more dividends in the future.
Imagine that an investor buys a share for $ 10,000 with a price of $ 100 who is currently paying a dividend of 4%. This investor owns 100 shares which all pay a dividend of $ 4 per share, or $ 400 in total. Suppose the investor uses the $ 400 dividend to buy four additional shares at $ 100 per share. If nothing else changes, the investor will have 104 shares next year which will bring in a total of $ 416 per share, which can be reinvested in more shares again.
While high dividend yields are attractive, they can come at the expense of growth potential. Each dollar that a company pays in dividends to its shareholders is a dollar that it does not reinvest to grow and generate capital gains. Shareholders can earn high returns if the value of their shares increases while they hold them.
Evaluating a stock based solely on its dividend yield is a mistake. Dividend data may be old or based on incorrect information. Many companies have a very high return because their shares are falling, which usually happens before the dividend falls.
The dividend yield can be calculated from the financial report for the last full year. This is acceptable during the first months after the publication of the company’s annual report; however, the more it has passed since the annual report, the less the data will be relevant to investors. Alternatively, investors will total the last four quarters of dividends, which captures the last 12 months of dividend data. Using a final dividend number is good, but it can make the yield too high or too low if the dividend has recently been reduced or increased.
Since dividends are paid quarterly, many investors will take the last quarterly dividend, multiply it by four, and use the product as an annual dividend to calculate the return. This approach will reflect any recent change in the dividend, but not all companies pay an equal quarterly dividend. Some companies, especially outside the United States, pay a small quarterly dividend with a large annual dividend. If the dividend is calculated after the large dividend distribution, it will give an inflated yield. Finally, some companies pay a dividend more frequently than every quarter. A monthly dividend could cause the dividend yield to be calculated too low. When deciding how to calculate the dividend yield, an investor should look at the dividend payment history to decide which method will yield the most accurate results.
Investors should also be careful when assessing a company that appears to be struggling with an above-average dividend yield. Since the share price is the denominator of the dividend yield equation, a strong downward trend can significantly increase the calculation quotient.
For example, the manufacturing and energy divisions of General Electric Company (GE) began to underperform from 2020 to 2020, and the stock price fell due to lower profits. The dividend yield went from 3% to more than 5% with the fall in the price. As you can see in the following graph, the fall in the share price and the possible fall in the dividend offset any advantage of the high dividend yield.
Example of dividend yield
Suppose that the shares of Company A are trading at $ 20 and pay annual dividends of $ 1 per share to its shareholders. Also assume that Company B’s shares are trading at $ 40 and also pay an annual dividend of $ 1 per share.
This means that the dividend yield of company A is 5% ($ 1 / $ 20), while the dividend yield of company B is only 2.5% ($ 1 / $ 40). Assuming that all other factors are equivalent, an investor seeking to use his portfolio to supplement his income, he would probably prefer company A to company B, because it has double the dividend yield.