What is Dividend Yield?
The dividend yield, expressed as a percentage, is a financial ratio that shows how much a company pays out in dividends each year relative to its stock price.
Introduction To Dividend Yields
- The dividend yield is the amount of money a company pays shareholders (over the course of a year) for owning a share of its stock divided by its current stock price—displayed as a percentage.
- Mature companies tend to pay dividends, with companies in the utility and consumer staple industries often having higher dividend yields.
- Real estate investment trusts (REITs), master limited partnerships (MLPs), and business development companies (BDCs) pay higher than average dividends, but the dividends from these companies are taxed at a higher rate.
- Higher dividend yields aren’t always attractive investment opportunities, as their dividend yield could be elevated due to a declining stock price.
Understanding 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 it will fall when the price of the stock rises. Because dividend yields change with the stock price, it often looks unusually high for stocks that are falling quickly. Some stock sectors, like consumer non-cyclical or utilities, will pay a higher-than-average dividend. Small, newer companies that are still growing quickly 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 tech stocks is lower than average, the rule about mature companies applies to a sector like this as well. For example, as of May 07, 2020, Qualcomm Incorporated (QCOM), an established telecommunications equipment manufacturer, has a trailing twelve months (TTM) dividend of $2.48. Using its current price of $78.83, its dividend yield would be 3.15%. Meanwhile, Square, Inc. (SQ), a relatively new mobile payments processor, pays no dividends at all.
The dividend yield may not tell you much about what kind of dividend the company pays. For example, the average dividend yield in the market is highest among real estate investment trusts (REITs) like Public Storage (PSA). However, those are the yields from ordinary dividends, which are a little different than the more common qualified dividends.
Along with REITs, master limited partnerships (MLPs) and business development companies (BDCs) also have very high dividend yields. These companies are all structured in such a way that the U.S. Treasury requires them to pass through most of their income to their shareholders. The pass-through process means the company doesn’t have to pay income taxes on profits distributed as a dividend, but the shareholder has to treat the payment as “ordinary” income and pay taxes on them. These dividends do not “qualify” for capital gains tax treatment. The higher tax liability on ordinary dividends lowers the effective yield the investor has earned. However, adjusted for taxes, REITs, MLPs, and BDCs still pay dividends with a higher-than-average yield.
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, more than 82% of the total returns from the S&P 500 are from dividends. This is true because it assumes that investors will reinvest their dividends back into the S&P 500, which compounds their ability to earn more dividends in the future.
Imagine an investor buys $10,000 worth of a stock with a $100 share price that is currently paying a dividend yield of 4%. This investor owns 100 shares that all pay a dividend of $4 per share, or $400 total. Assume that the investor uses the $400 in dividends to purchase four more shares at $100 per share. If nothing else changes, the investor will have 104 shares the next year that pay a total of $416 per share, which can be reinvested again into more shares.
Disadvantages of Dividend Yields
While high dividend yields are attractive, they may come at the cost of growth potential. Every dollar a company is paying in dividends to its shareholders is a dollar that the company is not reinvesting to grow and generate capital gains. Shareholders can earn high returns if the value of their stock increases while they hold it.
Evaluating a stock based on its dividend yield alone is a mistake. Dividend data can be old or based on erroneous information. Many companies have a very high yield as their stock is falling, which usually happens before the dividend is cut.
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 will be for investors. Alternatively, investors will total the last four quarters of dividends, which captures the trailing 12 months of dividend data. Using a trailing dividend number is good, 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.
Investors should also be careful when evaluating a company that looks distressed with 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.
Example of Dividend Yield
Suppose Company A’s stock is trading at $20 and pays annual dividends of $1 per share to its shareholders. Also, 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, as it has double the dividend yield.