A stock’s dividend yield is how much the company annually pays out in dividends to shareholders, typically expressed in a percentage.
For investors, that number matters. For an investor interested in total return, the dividend yield supplements the return the stock produced over the course of a year.
For example, if an investor owns $10,000 of stock with a dividend yield of 6%, they could expect to receive an annual dividend income of $600 from that stock. How often dividends are paid can vary, but most companies issue their dividends quarterly, which means the investor would receive that income in the form of four $150 installments.
It’s important to note that a stock’s dividend yield will fluctuate from year to year. That’s because the yield is based partly on the stock’s price, which will likely fluctuate from day to day. And companies pay investors based on the number of shares they own, not the cash value of their investment.
How to Calculate Dividend Yield
The dividend yield formula is straightforward: Dividend yield is calculated by taking the annual dividends paid out per share by a given stock, and then dividing it by the stock’s price per share.
Investors can calculate the annual dividend of a given company by looking at its annual report, or its quarterly report, finding the dividend payout per quarter, and multiplying that number by four. For a stock with fluctuating dividend payments, it may make sense to investigate the four most recent quarterly dividends to arrive at the trailing annual dividend.
Dividend Yield: Pros and Cons
For investors, especially retired investors, dividends can be a valuable income source, which has the benefit of allowing them to enjoy cash flow while keeping their investments. This is a unique and attractive proposition.
As such, it would seem natural that many investors would want to learn how to calculate dividend yield and then go for the stocks with the highest possible yields. But there are some factors to consider.
High Dividends Could Mean Slow Growth
Companies with higher dividends have unique profiles, and are often larger, more established businesses. That’s why their leadership will choose to give cash directly to shareholders, rather than pouring those profits into expansion or new business opportunities.
But that also means that dividend-generous companies are likely not growing very quickly.
Smaller companies, with aggressive growth targets, are unlikely to offer dividends, simply because they spend their profits on expansion. And for investors with longer-term goals, a portfolio with a heavy emphasis on dividends could mean missing out on the growth offered by these fast-growing sectors of the stock market.
A High Dividend Yield Could Indicate a Troubled Company
Because of how dividend yield is calculated, an especially high number can be a sign that a company is in trouble. The yield could have shot up because the dividend stayed steady while the stock’s share price has dropped dramatically. And most often, when a company is in trouble, one of the first things it is likely to reduce or eliminate is that dividend.
For example, during the early days of the COVID-19 crisis, companies that had offered dividends for years and even decades suddenly cut or canceled their dividends. During times when a company is struggling, it sends a bad message to pay cash to investors while eliminating jobs. And the period at the beginning of 2020 served as a very recent reminder for investors that dividend yields are not a sure thing. Even for the largest companies, they vary over time, and can even vanish.
The Higher the Dividend, the Greater Potential for Tax Implications
It’s important to look at how companies award dividends, and what that means from a tax perspective. While dividends can come in the form of cash or more stock, they’re usually paid out as cash by U.S. companies. As a result, dividends can be taxed as income.
Taxes on qualified dividends (generally, those paid on stocks held by an investor for more than 60 days) are paid at long-term capital gains rates. These rates can range from 0% to 20% (based on an investor’s modified adjusted gross income).
Tax rates for unqualified, or ordinary, dividends correspond with the investor’s tax bracket. The highest Federal income-tax rate in 2020 was 37%.
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Putting Dividend Yield in Context
Two companies with the same high yields are not created equally. While dividend yield is an important number for investors to know when determining the annual cash flow they can expect from their investments, there are deeper indicators that investors may want to investigate to see if a dividend-paying stock will continue to pay in the future.
A History of Dividend Growth
When researching dividend stocks, one place to start is by asking if the stock has a history of dividend growth. A regularly increasing dividend is an indication of earnings growth and a company’s overall financial health.
The Dividend Aristocracy
There is a group of S&P 500 stocks called Dividend Aristocrats, which have increased the dividends they pay for at least 25 consecutive years. Every year the list changes, as companies raise and lower their dividends.
Currently, there are 65 companies that meet the basic criteria of increasing their dividend for a quarter century straight. They include big names in energy, industrial production, real estate, defense contractors and more. And for investors looking for steady dividends, it may be a good place to start.
Dividend payout ratio (DPR)
Investors can calculate the dividend payout ratio by dividing the total dividends paid in a year by the company’s net income. By looking at this ratio over a period of years, investors can learn to differentiate among the dividend stocks in their portfolios.
A company with a relatively low DPR is paying dividends, while still investing heavily in the growth of its business. If a company’s DPR is rising, that’s a sign the company’s leadership likely sees more value in rewarding shareholders than in expanding. If its DPR is shrinking, it’s a sign that management sees an abundance of new opportunities abounding. In extreme cases, where a company’s DPR is 100% or higher, it’s unlikely that the company will be around for much longer.
Other Indicators of Company Health
Other factors to consider include the company’s debt load, credit rating, and the cash it keeps on hand to manage unexpected shocks. And as with every equity investment, it’s important to look at the company’s competitive position in its sector, the growth prospects of that sector as a whole, and how it fits into an investor’s overall plan. Those factors will ultimately determine the company’s ability to continue paying its dividend.
The dividend yield formula can be a valuable starting point for investors, and not just ones who are seeking cash flow from their investments.
Dividend yield shows how much income investors can likely expect, but there are other factors to consider when researching stocks that pay out dividends. A history of dividend growth and DVR, as well as the company’s debt load, cash on hand, and credit rating can all help form an overall picture of a company’s health and probability of paying out high dividends in the future.
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