What is dividend yield? It’s an excellent question for budding investors.
Dividends are one of only two reasons to own stocks and the only reason you can rely on stock to any extent. Dividends are the payments publicly traded companies pay to their investors, and the dividend yield measures how much payment you can expect relative to your investment.
What is Dividend Yield?
So, to dig in deeper, what is a dividend yield? The dividend yield is more important than the dividend amount and should be the first and last metric when choosing a dividend stock. The dividend amount could be $1,000 per quarter per share, and the yield is only 1% — this doesn’t amount to much and is less than the average S&P 500 stock. Furthermore, shares that yield 1% while paying $4,000 yearly have an astronomical and prohibitively high share price.
The dividend yield is the rate of return you can expect from a given investment, which is very similar to the yield on a savings account. The difference is that dividend payments and their yields usually pay out at the whim of a board of directors. In this light, a stock that costs $10 and pays a sustainable 5% yield is much more attractive than any dividend stock that pays a mere 1%, no matter how much the payment is in dollars.
Understanding Dividend Yield
The dividend yield is a stock’s income relative to its share price. Expressed as a percentage, it tells investors what income they can expect from a stock in the future.
How to Calculate Dividend Yield
The dividend yield formula is easy to calculate. Here’s how to calculate dividend yield: Divide the annual dividend payment by the stock price and express that as a percentage. For example, a stock that trades for $100 and pays $1 has a 1% yield.
Pros of Dividend Yield
There are many reasons to own dividend stocks, and here is a short list of the top reasons. You can find top dividend stocks using a dividend stock tool.
- Income generation: The number one reason to own dividend stocks is to generate income. Dividend stocks pay you to hold them, and you can use dividends to reinvest, pay bills or for other purposes.
- Enhance total returns: Dividend yield can enhance a portfolio’s total return or the combined gain of capital appreciation and dividend payments.
- Compounding investments: The dividend yield is great for compounding investments. The distribution amount will increase each quarter if you use dividend payments to purchase more shares. If the distribution grows as well, investors can achieve a double-digit compound annual growth rate (CAGR).
- Dividend capture strategy: You don’t have to own dividend stocks for more than a day to get the payment. The dividend capture strategy relies on the dividend ex-date vs. the day of record and allows for quick income with less risk.
Cons of Dividend Yield
Dividends, as good as they are, have some negative aspects as well, including the following:
- Double taxation: The money used to pay dividends is taxed twice because the company pays taxes on its earnings, and then you pay taxes on your investment gains. This has led to some intense criticism of the tax code, but it is not a reason to avoid dividend stocks.
- Income vs. growth: Dividend-paying stocks, specifically the blue-chip dividend growth stocks like Dividend Aristocrats and Dividend Kings, are not in a growth phase. You may not see appreciable capital gains while holding them because growth has already occurred or prices into the market.
- Diversification vs. income: You can get diversification with dividend stocks, but it is more challenging for non-dividend-specific portfolios.
Example of Dividend Yield
A div yield is the amount of distribution an investor can expect relative to the initial investment. Dividend yield changes over time, along with fluctuations in price. Yield can also be used as a trigger for entering a top dividend stock.
If a stock pays $3 per share in dividends annually and costs $100 to buy the stock, the yield is 3%. One sector that pays well-known dividends is the consumer staples sector, which yields about 2.35% on average. Stocks within the group have yields that range from 4% or better to under 2%. In some cases, they fall in the 1% range. Remember, it’s not the number of dividend stocks you own; it depends on the quality.
Evaluating Dividend Yield
The dividend yield is easy to evaluate. The yield of most stocks relates to pertinent data, including the most basic metrics of comparison. After the yield itself, you may be interested in the payout ratio, the CAGR and the number of years of dividend increases. The payout ratio is the amount of earnings a company pays in the form of dividends.
A higher payout ratio may indicate that a company pays out most of its income to investors. The dividend distribution could change if it needs to buy something or has an unexpected expense pop up. A low payout ratio is better because it means the company retains a large portion of earnings that it can use to strengthen its balance sheet, expand the business or buy back and retire shares.
The CAGR is the average annual growth over a set time, usually three or five years. A higher CAGR is always better, but the higher the CAGR, the higher the unsustainable growth trajectory. A stock with a 5% CAGR might grow its dividend yearly for many decades at the same pace, while one with a 15% or 20% CAGR should slow increases over time.
The number of years of increases can also help you make decisions. Stocks with a history of sustained annual increases are usually well-run, and you may rely on them for future payments and dividend increases.
Finally, you should always check the balance sheet to see if you should worry about excessive debt. Most companies have some debt, but it should be manageable and not involve too much cash flow.
Some metrics of interest may include the leverage ratio and the coverage ratio. The leverage ratio shows debt relative to equity the company has on the books. Lower debt relative to equity is better — under three times is very good. The coverage ratio tells the company’s ability to service its debt, so higher is better. A company with low debt and a high converge ratio should have plenty of room on the books to pay dividends and increase the distribution.
Why You Should Use Dividend Yield
Dividend yield is a valuable tool for investors. It tells you how much income a stock generates, and you can use it to evaluate a stock’s health and even its attractiveness relative to peers. For example, when looking at two stocks that are fundamentally equal in every way, the yield could be a deciding factor.
If one stock pays more than the other or has a better outlook for distribution growth, then it is most likely the better buy. If the yield is excessively high, it could signal a red flag. You might want to look for a higher payout if it is too low.
Should You Only Buy Stocks with High Dividend Yield?
High-yield investing is an essential subset of dividend investing. High-yield investors try to maximize their portfolio returns by only focusing on higher-yielding investments. However, first, define “high yield.” High yield could include any stock that pays more than the broad market S&P 500 average. In late 2022, that was about 1.5%, which was less than half the yield on the 10-year treasury at the time. In other cases, high yield may mean choosing the highest-yielding stocks in a sector, regardless of the payout relative to other sectors.
For others, high-yield investing means targeting stocks with truly high yields — yields above 5% and 10%, in some cases. However, many of the issues on Wall Street that pay those kinds of returns are unsustainable, irregular or erratic, which can lead to excessive volatility and loss of capital.
High-yield stocks may return capital to shareholders and not pay dividends from profits, causing erosion of shareholder value. Focus on high- or higher-yielding stocks but not necessarily at the slam-dunk win that it looks like at face value.
Dividends: Why Investors Buy Stocks
Dividends are one of the most critical aspects of the stock market. Some stocks, like the Dividend Aristocrats and Dividend Kings, have increased their payments yearly for decades. A stock with decades of annual dividend increases has already proven its value and ability to navigate uncertain times.
Have questions about dividends and dividend yield? Let’s take a look at some answers to commonly asked dividend questions.
What does the dividend yield tell you?
The dividend yield tells you the amount of payment a stock distributed to its investors as a percentage of stock price. The higher the yield, the larger the payment relative to the stock price.
Why is dividend yield important?
The dividend yield is significant because it measures return on investment dollars. The higher the yield, the better, in most cases.
What is a good dividend yield?
A good dividend yield is one the investor is happy with, and the company can sustain. Steer clear of an unsustainable dividend, no matter the yield.