What Is the Dividend Yield?
The dividend yield is a financial ratio that shows how much a company pays out in dividends each year relative to its stock price. The reciprocal of the dividend yield is the total dividends paid/net income which is the dividend payout ratio.
Key Takeaways
- The dividend yield—displayed as a percentage—is the amount of money a company pays shareholders for owning a share of its stock divided by its current stock price.
- Mature companies are the most likely to pay dividends.
- Companies in the utility and consumer staple industries often have relatively higher dividend yields.
- Real estate investment trusts (REITs), master limited partnerships (MLPs), and business development companies (BDCs) pay higher than average dividends; however, the dividends from these companies are taxed at a higher rate.
- It's important for investors to keep in mind that higher dividend yields do not always indicate attractive investment opportunities because the dividend yield of a stock may be elevated as a result of a declining stock price.
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Understanding Dividends
Before we jump into looking at the dividend yield, let's briefly explore dividends. Dividends are payments made by a corporation to its shareholders, usually derived from the company's profits. These payments represent a portion of the company's earnings that is distributed to its investors as a reward for their ownership.
Dividends can be issued in various forms, including cash payments, additional shares of stock, or other property. The most common form is cash dividends which is what this article focuses on.
Companies that generate consistent and stable profits may be more likely to pay regular dividends. In contrast, companies in high-growth phases may prefer to reinvest profits back into the business rather than distribute them to shareholders. The dividend policy can therefore provide insights into a company’s financial health and management’s confidence in future earnings. A company's dividend history also provides insights into management's future plans (i.e. reinvest for growth or reward current investors).
Absolute dividend dollars may not tell the entire story. For example, two companies may each issue a $1 quarterly dividend and have the exact same market capitalization. However, if one company's stock is valued at $100 and the other's is valued at $300, one company is paying significantly more relative to what the company may be worth. For this reason, it's worth now moving into the dividend yield.
Understanding the Dividend Yield
The dividend yield is an estimate of the dividend-only return of a stock investment. Assuming the dividend is not raised or lowered, the yield will rise when the price of the stock falls. Conversely, it will fall when the price of the stock rises.
Because dividend yields change relative to the stock price, it can often look unusually high for stocks that are falling in value quickly. New companies that are relatively small, but still growing quickly, may pay a lower average dividend than mature companies in the same sectors. In general, mature companies that aren't growing very quickly pay the highest dividend yields.
REITs, MLPs, and BDCs
In some cases, the dividend yield may not provide that much information about what kind of dividend the company pays. For example, the average dividend yield in the market can be very high amongst real estate investment trusts (REITs). However, those are the yields from ordinary dividends, which are different than qualified dividends in that the former is taxed as regular income while the latter is taxed as capital gains.
Along with REITs, master limited partnerships (MLPs) and business development companies (BDCs) typically can also have very high dividend yields. The structure of these companies is such that the U.S. Treasury requires them to pass on the majority of their income to their shareholders. This is referred to as a "pass-through" process, and it means that the company doesn't have to pay income taxes on profits that it distributes as dividends.
A high dividend yield may not always be great. For example, a company may be better off retaining cash to expand its company so investors are rewarded with higher capital gains via stock price appreciation.
Calculating the Dividend Yield
The formula for dividend yield is as follows:
DividendYield=PricePerShareAnnualDividendsPerShare
The dividend yield can be calculated from the last full year's financial report. Alternatively, investors can also add the last four quarters of dividends, which captures the trailing 12 months of dividend data. Using a trailing dividend number is acceptable, but it can make the yield too high or too low if the dividend has recently been cut or raised.
Because dividends are paid quarterly, many investors will take the last quarterly dividend, multiply it by four, and use the product as the annual dividend for the yield calculation. This approach will reflect any recent changes in the dividend, but not all companies pay an even quarterly dividend. Some firms, especially outside the U.S., pay a small quarterly dividend with a large annual dividend. If the dividend calculation is performed after the large dividend distribution, it will give an inflated yield.
Finally, some companies pay a dividend more frequently than quarterly. A monthly dividend could result in a dividend yield calculation that is too low. When deciding how to calculate the dividend yield, an investor should look at the history of dividend payments to decide which method will give the most accurate results.
Advantages of Dividend Yields
Historical evidence suggests that a focus on dividends may amplify returns rather than slow them down. For example, according to analysts at Hartford Funds, 69% of the total returns from the are from dividends. This assumption is based on the fact that investors are likely to reinvest their dividends back into the S&P 500, which then compounds their ability to earn more dividends in the future. Note that any historical statistics about dividends may not be reflective of dividends in the future.
A company's ability to consistently pay and increase dividends is often a strong indicator of its financial health and stability. Companies that generate sufficient profits and cash flow are more likely to distribute dividends to their shareholders. Therefore, a stable or growing dividend yield can be a signal that a company is in good financial standing.
Regular dividend payments can also boost shareholder confidence, signaling that management is confident in the company’s future prospects and earnings potential. This consistent payout demonstrates that the company generates sufficient profits to share with its shareholders. Not only is this another signal of good financial health, it can be an indicator that management has a plan for the future and believes it does not need cashflow for future success.
Disadvantagesof Dividend Yields
While high dividend yields are attractive, it's possible they may be at the expense of the potential growth of the company. It can be assumed that every dollar a company is paying in dividends to its shareholders is a dollar that the company is not reinvesting to grow and generate more capital gains. Even without earning any dividends, shareholders have the potential to earn higher returns if the value of their stock increases while they hold it as a result of company growth.
It's not recommended that investors evaluate a stock based on its dividend yield alone. Dividend data can be old or based on erroneous information. Many companies have a very high yield as their stock is falling. If a company's stock experiences enough of a decline, it may reduce the amount of the dividend, or eliminate it altogether.
Investors should exercise caution when evaluating a company that looks distressed and has a higher-than-average dividend yield. Because the stock's price is the denominator of the dividend yield equation, a strong downtrend can increase the quotient of the calculation dramatically.
Dividend Yield vs. Dividend Payout Ratio
Whencomparing measures of corporate dividends, it's important to note that thedividend yieldtells you what the simple rate of return is in the form ofcash dividendsto shareholders.
However, thedividend payout ratiorepresents how much of a company's net earnings are paid out as dividends. While the dividend yield is the more commonly used term, many believe the dividend payout ratio is a better indicator of a company's ability to distribute dividends consistently in the future. The dividend payout ratio is highly connected to a company'scash flow.
Thedividend yield shows how much a company has paid out in dividends over the course of a year. The yield is presented as a percentage, not as an actual dollar amount. This makes it easier to see how much return the shareholder can expect to receive per dollar they have invested.
Dividends can be awarded as additional stock, cash, or other forms of consideration. Keep this in mind when calculating the value of dividends received.
Tax Considerations of Dividends
It'd be remiss to talk about dividend yield without highlighting the tax treatment of dividends. The tax treatment of dividend income varies significantly across different jurisdictions and can ultimate influence investors' net returns.
In the United States, for example, qualified dividends are taxed at a lower rate than ordinary income, with rates ranging from 0% to 20% depending on the investor's tax bracket. This preferential treatment is designed to encourage investment in dividend-paying stocks. Non-qualified dividends, however, are taxed at the individual's regular income tax rate, which can be substantially higher.
The reason this is important to note is that the dividend yield may not ultimately be an investor's rate of return. If the taxpayer has a high individual tax rate, the investor's true net take-home proceeds may be 20% less than the dividend yield. Just as capital gains can vary based on the retirement vehicle in which they are held, dividends and their associated dividend yield may be impacted by taxes.
Dividend Yield Considerations and Inflation
Dividend yields can serve as an effective hedge against inflation, helping investors preserve their purchasing power over time. When companies pay dividends, they provide a regular income stream that can be particularly valuable during periods of rising prices. For instance, as a company's revenue grows potentially due to charging higher prices to capture inflationary pressure, that growth could be passed along to investors.
However, this is only true when dividend payments increase. Should a company decide to retain cash flow for growth purposes, a stable dividend yield may be unfavorable, especially during inflationary periods. For instance, during the global pandemic when the United States saw unprecedented government stimulus that resulted in high inflation, corporations that did not increase their dividend yield actually eroded the purchasing power of those dividends.
General Example of Dividend Yield
Suppose Company A’s stock is trading at $20 and pays annual dividends of $1 per share to its shareholders. Suppose that Company B's stock is trading at $40 and also pays an annual dividend of $1 per share.
This means Company A's dividend yield is 5% ($1 / $20), while Company B's dividend yield is only 2.5% ($1 / $40). Assuming all other factors are equivalent, an investor looking to use their portfolio to supplement their income would likely prefer Company A over Company B because it has double the dividend yield.
Real-World Example of Dividend Yield
To calculate the dividend yield for a company like Microsoft, you would follow these steps:
- Find the Annual Dividend Per Share: This is the total dividends paid per share over a year.For Microsoft, the annual dividend is$3.00per share.
- Determine the Current Share Price: This is the price of one share of the company’s stock.As of the latest data, Microsoft’s stock price was$414.67. Note that Microsoft's stock price will have fluctuated from the publication of this article, and this information is meant to demonstrate a historical example only.
- Use the Dividend Yield Formula: The formula to calculate the dividend yield is listed above; this means that Microsoft's dividend yield is approximately 0.72%.
What Does the Dividend Yield Tell You?
The dividend yield is a financial ratio that tells you the percentage of a company’s share price that it pays out in dividends each year. For example, if a company has a $20 share price and pays a dividend of $1 per year, its dividend yield would be 5%. If a company’s dividend yield has been steadily increasing, this could be because they are increasing their dividend, because their share price is declining, or both. Depending on the circ*mstances, this may be seen as either a positive or a negative sign by investors.
Why Is Dividend Yield Important?
Some investors, such as retirees, are heavily reliant on dividends for their income. For these investors, the dividend yield of their portfolio could have a meaningful effect on their personal finances, making it very important for these investors to select dividend-paying companies with long track records and clear financial strength. For other investors, dividend yield may be less significant, such as for younger investors who are more interested in growth companies that can retain their earnings and use them to finance their growth.
Is a High Dividend Yield Good?
Yield-oriented investors will generally look for companies that offer high dividend yields, but it is important to dig deeper in order to understand the circ*mstances leading to the high yield. One approach taken by investors is to focus on companies that have a long track record of maintaining or raising their dividends, while also verifying that those companies have the underlying financial strength to continue paying dividends well into the future. To do so, investors can refer to other metrics such as the current ratio and the dividend payout ratio.
Which Stock Has the Highest Dividend Yield?
This will depend on the timeframe you look at. Dividend yields change daily as the prices of shares that pay dividends rise or fall. Some stocks with very high dividend yields may be the result of a recent downturn in share price, and oftentimes that dividend will be slashed or eliminated by the managers if the stock price does not soon recover.
The Bottom Line
Many stocks pay dividends to reward their shareholder. High-yielding dividend stocks can be a good buy for some value investors, but may also signal that a stock's share price has recently fallen by quite a bit, making the legacy dividend comparatively higher in relation to the share price. A high dividend yield could also suggest that a company is distributing too much profits as dividends rather than investing in growth opportunities or new projects.
Correction - January 10, 2023: This article was corrected from a previous version that incorrectly stated the formula for the dividend payout ratio.
