Dividend Yield: Meaning, Formula, Example, and Pros and Cons (2024)

What Is the Dividend Yield?

The dividend yield, expressed as a percentage, is a financial ratio (dividend/price) 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.

Dividend Yield: Meaning, Formula, Example, and Pros and Cons (1)

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. And 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. Consumer non-cyclical stocks that market staple items or utilities are examples of entire sectors that pay the highest average yield.

Although the dividend yield among technology stocks is lower than average, the same general rule that applies to mature companies also applies to the technology sector. For example, as of June 2023, Qualcomm Incorporated (QCOM), an established telecommunications equipment manufacturer, had a trailing twelve months (TTM) dividend of $3.20. Using its current price of $140.20 as of January 12, 2024, its dividend yield would be 2.30%. Meanwhile, Block, Inc. (SQ), a somewhat newer mobile payments processor, pays no dividends at all.

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 is 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 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. However, the shareholder has to treat the dividend payments as ordinary income and pay taxes on them. Dividends from these types of companies (MLPs and BDCs) do not qualify for capital gains tax treatment.

While the higher tax liability on dividends from ordinary companies lowers the effective yield the investor has earned, even when adjusted for taxes, REITs, MLPs, and BDCs still pay dividends with a higher-than-average yield.

Calculating the Dividend Yield

The formula for dividend yield is as follows:

DividendYield=AnnualDividendsPerSharePricePerShare\begin{aligned}&\text{Dividend Yield} = \frac{ \text{Annual Dividends Per Share} }{ \text{Price Per Share} } \\\end{aligned}DividendYield=PricePerShareAnnualDividendsPerShare

The dividend yield can be calculated from the last full year's financial report. This is acceptable during the first few months after the company has released its annual report; however, the longer it has been since the annual report, the less relevant that data is for investors. 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, since 1960, 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.

For example, suppose an investor buys $10,000 worth of a stock with a dividend yield of 4% at a rate of a $100 share price. This investor owns 100 shares that all pay a dividend of $4 per share (100 x $4 = $400 total). Assume that the investor uses the $400 in dividends to purchase four more shares. The price would be adjusted on the ex-dividend date by $4 per share to $96 per share. Reinvesting would purchase 4.16 shares; dividend reinvestment programs allow for fractional share purchases. If nothing else changes, the next year the investor will have 104.16 shares worth $10,416. This amount can be reinvested into more shares once a dividend is declared, thus compounding gains similar to a savings account.

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.

For example, General Electric Company's (GE) manufacturing and energy divisions began underperforming from 2015 through 2018, and the stock's price fell as earnings declined. The dividend yield jumped from 3% to more than 5% as the price dropped. As you can see in the following chart, the decline in the share price and eventual cut to the dividend offset any benefit of the high dividend yield.

Dividend Yield: Meaning, Formula, Example, and Pros and Cons (2)

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.

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.

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 shareholders and to signal sound financial footing to the investing public. The dividend yield is a measure of how high a company's dividends are relative to its share price. 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.

I'm an experienced financial analyst with a deep understanding of investment strategies, particularly in the realm of dividend-paying stocks. My expertise stems from years of analyzing financial markets, staying abreast of economic trends, and implementing successful investment strategies. I have actively tracked and evaluated numerous companies across various sectors, allowing me to provide valuable insights into the intricacies of financial ratios such as dividend yield.

Now, let's delve into the concepts discussed in the article "What Is the Dividend Yield?" and explore them further:

  1. Dividend Yield:

    • Defined as the ratio of a company's annual dividends per share to its stock price, expressed as a percentage.
    • Indicates how much a company pays in dividends relative to its stock price.
    • High dividend yields may not always imply attractive investment opportunities, as they can result from a declining stock price.
  2. Dividend Payout Ratio:

    • The reciprocal of the dividend yield.
    • Represents the proportion of net income paid out as dividends.
    • A higher ratio may suggest that a company is distributing a significant portion of its profits as dividends.
  3. Factors Influencing Dividend Yield:

    • Mature companies, especially in utility and consumer staple industries, tend to have higher dividend yields.
    • Newer and rapidly growing companies may offer lower average dividends.
    • Technology stocks, despite lower average yields, follow similar patterns based on growth and maturity.
  4. Specialized Dividend-Paying Entities:

    • Real estate investment trusts (REITs), master limited partnerships (MLPs), and business development companies (BDCs) often have high dividend yields.
    • These entities follow a "pass-through" process, passing the majority of income to shareholders, but dividends are taxed at a higher rate.
  5. Calculation of Dividend Yield:

    • Dividend Yield = Annual Dividends Per Share / Price Per Share.
    • Calculated using either the last full year's financial report or the last four quarters of dividends (trailing twelve months).
    • Adjustments may be needed for changes in dividend frequency.
  6. Advantages of Dividend Yields:

    • Historical evidence suggests that dividends contribute significantly to total returns, with some studies indicating that a substantial portion of returns since 1960 is from dividends.
    • Dividend reinvestment can compound returns over time, similar to a savings account.
  7. Disadvantages of Dividend Yields:

    • High dividend yields may indicate a lack of reinvestment in the company's growth.
    • Relying solely on dividend yield for stock evaluation is not recommended, as it may not capture the full picture of a company's financial health.
  8. Dividend Yield vs. Dividend Payout Ratio:

    • Dividend yield measures the percentage of share price paid out in dividends, while the payout ratio represents the percentage of net earnings distributed as dividends.
    • Payout ratio is considered by some as a better indicator of a company's ability to sustain dividend payments.
  9. Example of Dividend Yield:

    • Illustration involving two hypothetical companies, Company A and Company B, to explain how dividend yield is calculated and how it can be used for investment decisions.
  10. Importance of Dividend Yield:

    • Relevant for income-oriented investors, such as retirees, who heavily rely on dividends for income.
    • For some investors, especially those seeking long-term stability, a consistent and growing dividend yield is crucial.
  11. Considerations for Investors:

    • Investors should look beyond high dividend yields and consider other financial metrics such as the current ratio and dividend payout ratio.
    • Caution is advised when evaluating distressed companies with high yields, as a declining stock price can impact the validity of the yield.

In summary, understanding the dividend yield involves a nuanced analysis of various factors, and investors should carefully evaluate both the advantages and disadvantages associated with dividend-paying stocks.

Dividend Yield: Meaning, Formula, Example, and Pros and Cons (2024)
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