What is dividend yield?
Dividend yield is the ratio of the dividends paid by a company to its shareholders relative to its current stock price. It is generally expressed as a percentage and is an indicator of the dividend-only return earned by the investor on a stock.
For example, if a company has an annual dividend of $3 per share and is currently trading at a stock price of $100, then its dividend yield is 3%.
Dividend yield formula
Most companies pay quarterly dividends. For such companies, the annualized dividend per share = 4 x quarterly dividend per share.
For companies that pay dividends on a monthly basis, like several REITs (Real Estate Investment Trusts), the annualized dividend per share = 12 x monthly dividend per share.
There are two types of Dividend Yield: Trailing Dividend Yield and Forward or Leading Dividend Yield.
Generally, Forward Dividend Yield is considered a better measure as it takes into account any dividend hike, cut, or suspension of dividends announced by the company.
Why is dividend yield important?
Dividend yield is a key metric that indicates the return that an investor earns by way of dividends. Investors who seek steady income may invest in stocks with high yields. However, it is important not to assess a company’s dividend yield in isolation without considering other factors.
Aspects to consider before investing in dividend stocks
Dividend yield is based on the current stock price, it is therefore important to remember that the yield varies with stock price fluctuations. If a stock dividend is the same over a period of time, then dividend yield may appear high or elevated when the stock price is declining. So, if it is considerably higher than its peers, due to a fall in its price, then investors should be cautious as it could be a dividend trap.
Dividend yields vary across industries, generally, utilities and several consumer staples offer higher yields.
Important things to consider aside from the dividend yield include:
– Growth in dividends: Check if the company has been consistently growing its dividends. For instance, dividend aristocrats are companies that have raised their dividends for at least 25 consecutive years.
– Financial strength of the company: It is useful to assess the dividend payout ratio and check whether a company’s earnings and cash flows are good enough to sustain the payout ratio. It is also vital to check debt levels, as a company with high debt might lower its dividends or even suspend them in challenging times.
– Growth prospects: Not only dividend-paying stocks or high dividend yield stocks offer good investment opportunities. New and some high growth companies choose not to pay dividends or pay lower dividends, as they reinvest their profits in growth initiatives.
What Is the difference between dividend yield and total return?
The total return is a more comprehensive measure of return than dividend yield. While dividend yield is a measure of return based only on dividends, a total return takes into account dividends, any other distributions to shareholders, and capital gain (or loss) in the stock over a certain period of time.
Let’s look at the example of a fictional stock ABC, which has appreciated $20 to $100 over a period of one year and has paid an annual dividend of $5. The total return, in this case, will be:
Dividend yield vs. dividend payout ratio
The dividend Payout Ratio measures the percentage of net income that is distributed to shareholders in the form of dividends, while dividend yield helps to gauge the rate of return earned in the form of cash dividends relative to the stock price.
The dividend yield is a key financial metric that helps in choosing attractive dividend stocks. However, before making an investment in a dividend-paying stock, investors should carefully look into several other aspects, including growth in dividends paid, the financial strength of the company, and future growth prospects.