The dividend yield is the ratio of dividend/price. It shows how much a company pays out in dividends relative to its stock price. It is displayed in percentage and is a valuable metric that can tell you the performance of a stock in terms of the dividend value so if you are a dividend investor then you can take the decision easily whether you want to buy the stock or not.
How to calculate the dividend yield?
The formula for calculating dividend yield is as follows:
Dividend yield: Dividends paid per share annually/ Stock price per share
If a company’s annual dividend is $1 and the stock share price is $25 then the dividend yield will be 40% ($1/$25 * 100).
Assuming that the dividend is not increased or decreased then the yield will rise when the stock prices go down and it will decrease when the stock price goes up so we can see there is an inverse relationship between the stock price and dividend yield.
What is the use of this metric?
It helps investors know how much return they are getting on the investment they make. An investor will prefer a stock that has more dividend yield over the one that has less.
Let’s take one example, company A’s stock has a stock price of $25 and pays an annual dividend of $1 to the shareholders. Company B’s stock has a stock price of $50 and pays an annual dividend of $1 to the shareholders. The dividend yield for company A will be 40% and company B will be 20%. So, any investor will prefer company A’s stock as it gives a double dividend yield.
Investors who want minimum cash flow from the investments they make can invest in the stocks that pay high and stable dividend yields. New companies pay fewer dividends than well-established companies. Old companies have a good track record of paying consistent, stable dividend yields.
One should be aware of too-high yields
Now, high yields are good and every investor is in search of it but one should be aware of too-high yields. It will be quite weird to notice if a company is providing a big yield suddenly. Ask a question to yourself, why the company is providing a too-high yield?
If you pay attention to the formula of dividend yield then you will find that one of the reasons for a high dividend yield can be the low stock price.
If the stock price is decreasing then there are chances that the company may be having a financial loss and that’s why the stock prices are lower. This scenario is known as a “value trap”.
You need to know here why the stock prices of the company are falling down. If you see any possible dangers of the company running in loss then you will need to clear out all your investments. Consult a financial advisor for this and they will guide you as to what steps you should take now.
If there is a global recession and every stock is going down then there is not much need to worry as the stocks will rise back when the situation gets normal.
So, it is advised that one shouldn’t look at the dividend yield as the only measure to evaluate the performance of the stock. There are other factors too which must be checked to have a correct idea on how the stock is performing.
One thing you should know is that Master limited partnerships (MLPs) and real estate investment trusts (REITs) have a very high dividend yield and the reason for this is that they are forced by law to share a very high amount of their earnings among shareholders. This is called the “pass-through” process. With this, the company doesn’t have to pay income tax on profits that are distributed as dividends.
Some companies alter their growth cost to lure investors so one must be aware of this. A detailed analysis of 4-5 years of dividend yield of the company must be done to get a clear idea of the stock performance.
Important points to be noted for the dividend yield:
- It is a ratio of annual dividends paid/stock price.
- Mature companies pay more dividends than new companies.
- Investors must note one point that the higher dividend yields don’t always show a sign of good investment opportunities as the value of dividend yield may be increased due to the lowering stock price.
So, here was an overview of dividend yield and how to calculate dividends. Hope you got a clear idea of it and now can evaluate a stock on the basis of this metric.
You can keep a practice of checking out this metric when you are planning to get new stock on your portfolio, analyzing it will give you a better understanding as to how the stock has performed over the last few years and then you can make a sound decision whether to buy it or not. For more information, visit Financeshed.