One of the most widely used financial ratios to track income stocks is known as the dividend yield. The dividend yield, also referred to as the current yield, represents the annual dividends paid out by a company in relation to its share price. Basically, it is the return on investment that an investor could expect to get if they invested in the stock at the current price and the company continued to payout the same dividend.
While not a perfect representation of a company’s return on investment, the dividend yield is an important ratio that all income investors must understand.
Dividend Yield Calculation
Most income growth investors can easily pull the current yield of a company by looking up the stock information on financial websites or the company’s investor site. Another option is to actually run the calculation by hand to compute the current dividend yield of a stock.
The following equation can be used to calculate a stock’s current yield -
Yield = Annual Dividends / Current Share Price
If a stock has paid out $1.00 in dividends per share over the past 12 months and is currently trading at $25 per share, the current yield would equal .4 or 4%. This equation is represented below.
Current Yield = $1.00 / $25 or 4.0%
Using the Dividend Yield
Using the dividend yield is most effective for investors identifying new investment options. It is a way to compare multiple income stocks against each other, regardless of their sector or industry. For example, an income investor can compare the dividend yield between a banking stock and an energy stock, which will help guide the investment decision.
The current yield can also alert investors of a future dividend cut. As the share price of a stock decreases, the yield will initially rise (in some cases over 10%). Since this ratio is calculated using past dividend performance, a drop in share price could be the first signal that a company is considering a cut. It can take several weeks for the yield to actually represent this type of event.
Alternatives to the Current Yield
The current yield of a stock is often used to estimate the return on investment based on the current share price. The calculation also assumes that the annual dividend payout over the past 12 months will remain constant. While there are plenty of stocks that maintain or even raise their dividends, there will also be many companies that cut or eliminate dividends. A stocks share price will also continue to rise and fall making the current yield a moving calculation.
One alternative that is commonly used in place of the current yield is the yield on cost (YOC). This calculation represents the return on investment based on what the investor actually paid to own the stock. For blue chip growth stocks, the YOC can be much higher than the actual yield that a stock is currently returning.
Understanding how the dividend yield is calculated and what it represents is beneficial for investors of dividend paying stocks. The ratio represents the annual dividends paid out by the company in relation to it’s current share price. Investors will often use this value to help make investment decisions and understand the return on investment that they could earn by purchasing a stock.
How much weight do you put on the dividend yield in your stock analysis?