One of the most widely used financial ratios to track income stocks is known as the dividend yield.
Dividend yield can help you to establish the actual worth of your stocks and the risks and rewards associated with your investments.
Today we’ll be defining dividend yield, showing you how to calculate it, and explaining how you can use it to maximize your investments.
What Is Dividend Yield?
Dividends, or the payments shareholders receive from the companies they invest in, can be assessed using 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 pay out 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.
Knowing how to calculate stock dividend yield can help you decide on the best investment route for your money.
How to Calculate Dividend Yield
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
Now, let’s plug an example into the equation to see how it works.
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%
The dividend yield can be used for both preferred stocks and common stocks. While there are several differences between preferred stocks and common stocks, one stands out in the discussion of dividend yield.
With preferred stock, a corporation provides a set dividend, giving you a clearer idea of how much you will yield.
Unlike the preferred stockholder, as a common stockholder, you receive voting privileges for the number of shares you own and the dividend can fluctuate.
Due to that difference, preferred stockholders can have a better idea how much they will yield from the onset.
You can also use the equation to determine the trailing dividend yield and the forward dividend yield, which look at historical yield and projected future yield, respectively.
Since the common dividend is not a set value for common shares, you can look at the previous yields to gain insight.
Most Recent Full-Year Dividend/ Current Share Price= Current Yield
If you’re a common shareholder, here’s your best bet for tracking your potential dividend yield:
Share prices change and dividend increases and cuts occur frequently, but these measures can still serve as helpful analytical tools in your decision-making process.
How to Use 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.
Which Industries Have the Highest Dividend Yield?
For the investor open to any industry, trends in dividend yields can help suggest which field to invest in.
Based on common sense (and historic yield data), industries with steady foreseeable profits tend to have higher dividend yields than less predictable ones.
In other words, as research implies, you can depend on people paying for staples even in times of need, so industries like telecommunications and utilities are safe moneymakers no matter the economic climate.
Entertainment, communication, and more basic needs like electricity and water yield high dividends and will continue to thrive, making those industries solid investment choices.
But, what about less predictable industries?
Using popular screening techniques like S&P, we can see the yields of corporations and industries.
The American Association of Individual Investors, commonly known as AAII, screens companies to measure yields as well. AAII suggests looking at the following characteristics:
- Marked history of growing dividends
- A successful current yield in comparison to the historic yield
- Profits ahead of the field’s normal earnings
- Below average liability
Using those characteristics can help you determine which corporations you might want to invest in. The AAII screens top-20 dividend yields ranged from about 3% to 7%, to provide some insight.
With a bit of research on a corporation’s website, you can find the company’s annual dividends.
Plug those into the dividend yield equation with the current share price, then see how the current yield stacks up against the criteria above.
Figures change, but if the dividend yield checks off the aforementioned boxes, you could be looking at a worthwhile investment.
Which High-Dividend Shares You Should Avoid
While determining what shares to avoid investing in may be a bit more challenging, there are a few tips to keep in mind.
Looking at the checklist above raises an important point for dividend investment:
A high dividend yield percentage does not automatically equal a lucrative investment.
It’s critical to look at how that yield has changed over time and how it competes with other corporations in the industry.
Sometimes dividend stocks soar, but long-term success is bound to more than a high yield percentage. When a stock’s dividend yield is unusually high, look at the reasons why.
With that information in mind, use the dividend yield formula and compare how the yield has changed over time.
As you can see, high-yielding dividends can be misleading.
Also, you may want to proceed with caution with one particular investment industry: Real Estate Investment Trusts.
As analysts suggest, REITs like Realty Income can house dangerous investments under the guise of impressive monthly payments and a recent upswing in dividend worth; however, they actually yield lower than competitors and can’t keep up with technologically advanced industries.
To recap, avoid falling into dividend yield traps by comparing dividend yields to past figures, growth rates, and competitors.
Determining Dividend Cuts
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 example, consider blue chip growth stocks. Blue chip stocks are those which come from established companies with typical earnings in the billions who are considered financially stable for investment.
In the case of blue chip companies, 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 its current share price.
As an independent investor, you can use this value to help make investment decisions and understand the return on investment that you could earn by purchasing a stock.
Consider calculating dividend yield in determining your next investment.