The dividend yield is a financial ratio used by investors to understand how much a company is paying out in dividends relative to its share price.
The dividend yield is calculated as:
It is generally expressed as a percentage, and for stocks that pay a dividend, is generally in the range of 1% to 15%.
To calculate the dividend yield, we generally look at the most recent year’s dividends, or the total dividends for the most recent four quarters. We can also use the expected dividends for the next four quarters or for the coming year. This is call the prospective dividend yield.
We take the the annual dividend per share and divide it by the current stock price for the company to arrive at the dividend yield.
Why is the dividend yield important? Why don’t we just look at the dividends paid by the company?
A large dividend payout may look attractive, but this can be misleading without taking into account the share price. The more important metric is the dividend relative to the price paid for share, or the dividend yield.
Let’s look at an example to understand why the dividend yield is more important than the dividend.
We have two companies: Company A and Company B. The annual dividend per share is $12 for Company A and $25 for Company B. The current share price is $125 for Company A and $500 for Company B.
If we only look at the annual dividend, then Company B seems more attractive. But is this really true?
Let’s look at the dividend yield. The dividend yield for Company A is $12 / $125, which is 10%. The dividend yield for Company B is $25 / $500, which is 5%.
The dividend yield for Company A is higher, which means that Company A is actually more attractive than Company B.
To understand this more concretely, let’s say you have $5,000 to invest in either Company A or Company B. If you invest all of the $5,000 in Company A, you would have 40 shares of Company A. If you invest all of the $5,000 in Company B, you would have 10 shares of Company B.
What are the dividends that you would receive? Since the dividend per share for Company A is $12, you would receive 40 x $12, which is $480. For Company B, you would receive $25 x 10, which is $250. As suggested by the dividend yield, you would make more money investing in Company A solely based on the dividend yield.
The following table summarizes this example.
|Company A||Company B|
|Annual dividend per share||$12||$25|
|Dividends received per year||$480||$250|
Why do investors care about dividends? They care about it is one of two ways to make money in the stock market. The way you earn money on a stock is either through:
Dividends are cash returns that you actually receive on hand. Stock prices fluctuate — if you buy or sell at the wrong time, you could make no money or lose money — but you can lock in some of your gains through dividend income.
Put another way, capital gains are theoretical, but dividend income is very much real.
When investing, what dividend yields are considered to be good? First, dividend yields are open to interpretation.
A high dividend yield may signal a good investment opportunity, but it may also reflect a low share price, driven by expectations that the company may not be able to sustain future dividend payouts.
A low dividend yield could indicate a poor investment opportunity, or it could indicate that the company is planning to reinvest more of its earnings into the company rather than paying out dividends.
Generally, the dividend yield of a company should be compared within the sector it is in and against the market as a whole. The S&P 500 has an overall dividend yield of around 2%. This can give you a sense if the dividend yield is high or low.