Dividend Yield
Dividend yield is a financial indicator of a company, reflecting the ratio of the sum of dividends paid per year to its share price. Simply put, it is the dividend/price ratio. The price/dividend ratio is the opposite.
Understanding the Dividend Yield
If dividends don't increase or decrease, the yield will increase as the stock price decreases. If the stock price rises, the yield will fall. Dividend Yield reflects a valuation of a stock investment's return on dividends only. Dividend Yield depends on the stock price and can look very high for fast falling stocks.
New small, fast-growing companies can pay lower dividends than large, mature companies in the same industry. The highest dividend yields come from stable companies that are not growing very fast. The highest average dividend yields may come from consumer non-cyclical stocks. They represent basic goods or utilities sectors.
Technology companies have lower-than-average dividend yields, but the technology sector is also under the general rules.
Sometimes the dividend yield does not reflect the dividends paid by the company. For example, real estate investment trusts (REITs) have very high average dividend yields in the market. This refers to the yield on ordinary dividends, which are subject to income tax. The difference of qualified dividends is that they are subject to capital gains tax.
Master Limited Partnerships (MLPs) and Business Development Companies (BDCs) also have very high dividend yields. The U.S. Treasury requires them to distribute most of their income among their shareholders. In this case, the company distributes the profits as dividends and does not have to pay income tax. This is called the "pass-through" process. In this case, dividend distributions should be treated as ordinary income and shareholders should pay taxes on them. Capital gains taxes are not applicable to dividends of such companies (MLPs and BDCs).
The investor receives a lower effective dividend yield from ordinary companies because of high tax obligations. But even considering taxes on REITs, MLPs, and BDCs, investors receive dividends with above-average returns.
Calculating the Dividend Yield
Dividend Yield equation for calculating:
The basis for calculating the dividend yield can be the financial report for the last full year. This can be done in the first few months after the publication of the company's annual report, because the more time passes, the less relevant the data becomes for investors. Investors can request dividend information for the last 4 quarters, which will give an idea of the last 12 months. Past data can be used, but it can be inaccurate with changes in the present (may be overstated or understated).
Typically, dividends are paid on a quarterly basis. To calculate an annual dividend for yield estimation with all the recent changes, investors take the dividend for the last quarter and multiply by 4. This method doesn't work for all companies, because not all of them pay an equal quarterly dividend. Some companies pay small dividends for the quarters when the dividend for the year is large, but there is a risk of getting an inflated dividend figure if the calculation is based on a large dividend.
Some companies pay dividends for a period of time shorter than a quarter. Calculating the dividend yield based on monthly dividends will result in a too small dividend yield. An investor should read the company's dividend payout information before calculating the dividend yield. Based on this historical data, the calculation method for a more accurate result can be chosen.
Advantages of Dividend Yields
By analyzing information on previous payouts, we can conclude that returns are increasing, not decreasing, when oriented to dividends. Hartford Funds analysis of the S&P 500 total return shows that it has risen to 84% since 1970. This is probably due to investors reinvesting dividends back into the S&P 500. This contributes to an increase in potential future dividend earnings.
Disadvantages of Dividend Yields
The company's potential growth can contribute to a high dividend yield. Supposedly, every dollar that is not reinvested for company and capital growth is paid to shareholders in dividends. Shareholders still have the opportunity to earn higher returns without having dividends paid. When a company and the value of its stock grows, so does the income of its shareholders.
Dividend yield is not the only indicator for stock valuation. Dividend information can be incorrect or outdated. Many companies' stocks are falling, but their yields are very high. The lower a company's stock price, the lower the dividend. Sometimes dividends are not paid at all.
If the company looks problematic and its profitability is above average, then it is worth being cautious in estimating. The denominator of the dividend yield equation is the share price. This means that the coefficient of calculation can go up a lot in a downtrend.
Dividend Yield vs. Dividend Payout Ratio
Dividend yield is a monetary reflection of the shareholders' simple rate of return. This is the number of dividends paid by the company for the year. Yields are shown as a percentage, not a sum of money, which helps shareholders understand how much they can earn from each dollar they invest.
Dividend payout ratio is the part of a company's net income that is paid out in dividends. The dividend yield is more widely used, but the dividend payout ratio reflects the company's ability to consistently pay dividends in the future more accurately. A company's cash flow has a strong effect on the payout ratio.
