Summary - Dividend stocks have a place in every investor’s portfolio. The ability and willingness of a company to pass along a portion of their profits as income to its shareholders can be a key indicator of a mature, financially stable company. The size of their dividend yield can be a key factor when forming a comparison between one company and another. Dividend yield is simply the amount (in dollars) of a company’s current annual dividend per share divided by its current stock price. A company that pays $3 in dividends on an annual basis with a stock price of $90 has a dividend yield of 3%.
Dividends are most frequently paid to shareholders who own shares of a company’s common stock. Investors can, however, enjoy the benefits of dividend investing through mutual funds or a dividend yield ETF.
What is considered a good dividend yield depends a little on the company and a little on the investor. If an investor is comparing two utility companies with each other, then if all other factors are equal they may reasonably expect that the one with a higher dividend yield is a better investment. However, if they are comparing two companies from different industries or sectors, they will want to look at each company's performance with regard to their sector. It may turn out that a company has a lower dividend yield than others in its sector which can be a sign of other problems.
An investor will also base their decision on their own circumstances. Retirees who are investing for income will want to invest in stocks that provide a stable, reliable income. Younger investors may choose to only have a few dividend stocks in their portfolio and may be willing to settle for a low dividend yield because they are still putting capital appreciation above everything else.
Like other fundamentals, a dividend yield has to be looked at as only one part of a company’s overall financial picture. Analysts may sometimes punish a company for not meeting elevated expectations even though the company is still showing the ability to earn a profit. On the other hand, sometimes analysts may reward a company with a strong rating even though they are cutting their dividend.
Few investors would argue that dividend stocks don’t belong in their portfolio, particularly investors who are retired and counting on their investments to generate some income. One of the easiest investment strategies for these investors to pursue is to buy the dividend stocks that return the highest yield. A company that has a growing dividend yield is considered to be a financially stable company. Many well-established companies have been issuing and raising their annual dividends for 10, 25, and even 50 years – or more.
In this article, we'll break down the concept of dividend yield and explain why it is important to investors. Along the way, we'll review what a dividend is, why the definition of a good dividend yield will vary among investors and how the dividend yield is related to the dividend payout ratio. As we close the article, we’ll review how analysts’ expectations can affect a company’s dividend yield in ways that require much closer scrutiny from investors.
What is dividend yield?
A dividend yield (also called the dividend-price ratio) is simply a company’s dividend expressed as a percentage of its stock price. To calculate dividend yield use the following formula:
Dividend yield = Current annual dividend (per share)/Current stock price
Let’s look at a few examples:
Company A pays a total annual dividend of $0.80 per share. Their stock price on the day they declared the dividend was $20. Their dividend yield is:
0.8/20 = .04 or 4%
Company B pays a total annual dividend of $1.25 per share. Their stock price on the day they declared the dividend was $60. Their dividend yield is:
1.25/60 = .02 or 2%
Company C pays a total annual dividend of $5.00 per share on a stock price of $100. Their dividend yield is:
5/100 = .05 or 5%
Many formulas will leave out the word "current", but it is significant to understand the importance, and the fluid nature, of dividend yields. A company's annual dividend is commonly paid out four times throughout the year which is known as their quarterly dividend. Every quarter, when a dividend company issues its earnings report, they provide guidance to analysts regarding their intention to increase, decrease or keep their dividend payout for subsequent quarters. These forecasts are based on not only where the stock price is but where the company perceives the stock price will go. If the company's stock price goes higher, they may (depending on their dividend strategy and a number of other variables) increase its dividend payout to keep their yield at the same level or higher. By contrast, if their stock price declines, they may lower their anticipated dividend payout.
What is a dividend?
A dividend is a portion of a company’s profit that is paid back to shareholders. While in some cases, dividends are paid out directly as shares of stock (as opposed to a dividend reinvestment plan or DRIP - more on that below); most of the time investors receive cash dividends either as a direct deposit or as a paper check. Dividends are commonly associated with income stocks or growth and income stocks. This is because these stocks generally are choosing to reward their shareholders with cash as opposed to future earnings growth. This does not mean that these stocks will not grow, it simply means they are not expected to grow at the same rate as other stocks that will not choose to reinvest their profits into the company for faster growth which theoretically means a higher stock price and more value for investors in that way.
What does a dividend yield signify to investors?
In general, the ability and willingness of a company to pay a dividend are considered a strong indication that the company has a strong fundamental financial footprint. These companies frequently have solid balance sheets. In fact, a company that has a long history of not only paying but increasing their dividends belongs to a club called the dividend aristocrats. These companies are considered low-risk investments because they have shown a proven ability to issue regular dividends in both good and bad financial conditions.
What is a good dividend yield?
While the answer to this question depends a lot on an investor’s own objectives, a good baseline is 3-4%. One of the reasons for this is that many dividend-paying stocks give investors the opportunity to reinvest their dividends into a dividend reinvestment plan (called a DRIP). This is significant because it allows investors to buy more shares of the company without having to put out their own money.
Let’s use one of our examples above:
If Bill owned 1,000 shares of stock in Company A his investment would be worth $20,000 (1000 x 20). If he earns a total annual dividend of 0.80 per share, at the end of the year, he will have received a total of $240.00 in dividends. If he chooses to reinvest the dividends, Bill will be receiving more than ten additional shares by the end of the year. Assuming he buys no more additional shares, he will start the next year with just over 1,010 shares.
Of course, many income-oriented investors choose dividend stocks because they are counting on the income they receive from dividends to supplement their retirement savings.
For an investor with a portfolio of dividend stocks, you can see why dividend yield can be significant. However, sometimes chasing yield can be a difficult investment strategy. It’s far more important for an investor to look at the fundamentals of the company and make a decision as to how likely it will be for a company to continue paying a high dividend yield. Unfortunately, there are some companies that will offer a high dividend yield as a way of attracting investment dollars. These investors can be in for a rude awakening when the company slashes the dividend yield or stops issuing a dividend altogether.
There are also many investors, primarily younger investors with a long period of time until they will need the money from their investments, who are looking for capital appreciation above all else. These investors are looking for high growth stocks that generally avoid paying dividends as they prefer to put money into the company’s growth either through acquisitions or research and development. In some cases, these investors may still see the value of having dividend stocks in their portfolio, but they will likely choose stocks of companies that prioritize growth over a high current dividend yield.
The relationship between dividend yield and dividend payout ratio
As we've stated, dividend yield can be a misleading indicator of a company's financial health as well as the ability of a company to sustain its dividend. Many investors, in addition to looking at a company's dividend yield, will also look at their dividend payout ratio. This is the amount of a company's net income that goes towards dividends. The payout ratio can give investors a good picture of a company's free cash flow based on their willingness to offer a dividend.
A fast-growing biotech startup, for example, may choose to reinvest all – or most of their earnings into new product development. By choosing not to pay a dividend, their payout ratio would be zero.
An established company, such as Coca-Cola, Inc. or more commonly a utility company like Duke Energy may pay a substantial dividend. In the case of Coca-Cola, the company has a large market capitalization and is well past its initial growth stage. While investors expect some growth from the stock, they do not expect a meteoric rise. Utility companies, by contrast, are never known for significant growth but are known for consistent revenue streams that make their payout ratios and dividend yields a virtual lock.
How do analysts’ recommendations affect dividend yields?
Earnings season is one of the most volatile, and exciting, times in the stock market. For dividend-paying stocks, analysts will look through their balance sheet, listen in to their quarterly earnings call, and interview key executives at the company to make an assessment of the stock's future performance including the likelihood of increasing their dividend and the amount, if any, of that increase. One of the challenges for companies and investors is that analysts and companies sometimes do not agree on the forecast for earnings per share (EPS) and revenue.
Let’s look at an example, if Company C projects an increase of $0.50 to their annual dividend yield, it would mean their new projected dividend yield would be 5.5%. However, analysts are more optimistic and forecast a $0.75 dividend increase. If the company's profits rise, but only enough to allow them to increase their dividend yield by $0.50, their dividend yield would be lower than the analysts projected, however, it would have met the company's expectations. An investor may see this as a negative sign even though the company is showing higher revenue and profits.
On the other hand, a dividend cut does not always have to be negative. If after reviewing a company’s fundamentals, analysts foresee a dividend cut being a temporary measure to help the company build a stronger balance sheet that will improve their future performance, they may very well be rewarded by analysts and see their stock price increase.
The bottom line on dividend yield
One of the many benefits of dividend investing is the annual dividend yield that is typically paid out on a quarterly basis. For income-oriented investors, reliable and predictable regular income from dividends can make a difference in the quality of life in their retirement. The dividend yield formula is:
Dividend yield = Current annual dividend (per share)/Current stock price
So a Company that pays a total annual dividend of $0.80 per share with a stock price of $20 will have a dividend yield of 4%. Although there is no perfect answer to the question of what is considered an acceptable dividend yield, most investors consider a 3-4% annual dividend yield a good target particularly if they are planning to reinvest their dividends.
A limitation of using the dividend yield as a metric for investors is that it can misrepresent the financial health of a company based on its stock price. For example, a company with increased revenue and earnings per share that fall shorts of analysts’ recommendations may see their stock price – and therefore their dividend yield – decline even though they are operating a healthy business. Conversely, there are times when a company may proactively announce a reduction in its dividend to take care of some pressing financial issues. However, if analysts perceive this action as being one that can help the long-term health of the company, they may increase the company's stock price.