What Are Dividend Yields & How Are They Calculated?
Dividends and stock-price increases make up the total return on stock investments. Apart from representing a substantial portion of returns for investors, dividends also provide an income stream for the investor. Owning dividend-paying stocks can be a great way to compound wealth and beat inflation.
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What Is Dividend Yield?
A dividend is an amount a company pays from its profits or retained earnings to shareholders on record at a particular date. Dividing the total dividend by the total outstanding ordinary shares issued gives the dividend per share. Various companies have different frequencies of paying out their dividends, some monthly, quarterly, or annually depending on regulations or company policy.
The dividend yield is a ratio that shows the annual dividend amount per share paid by a particular company as a percentage of the share price. It indicates the percentage of income you expect based on the stock price at a specific date. It measures the return of a stock based on the dividend paid.
How to Calculate Dividend Yield
The formula for computing dividend yield is:
Dividend Yield = (Annual Dividend Per Share / Current Price Per Share) * 100
When calculating the dividend yield, investors use the annual dividend. Different companies have varying frequencies for dividend payments — monthly, quarterly, or annually. Therefore, if the dividend is a constant amount paid quarterly or monthly, it must be annualized. A sum of the different amounts provides the annual dividend for fluctuating dividends. For example, when calculating the dividend yield for a monthly payor, you must add the dividend payments for each of the 12 months.
Generally, we use the dividend per share from the last annual report to compute the dividend yield. However, as time progresses from the fiscal year-end, the dividend from the previous fiscal year becomes less relevant. It’s better to compute the yield based on the trailing 12-month (TTM) yield, the sum of dividends from the latest consecutive 12 months, or the most recent four quarters.
For example, Verizon has paid out a dividend of 0.64 in each of the last four quarters. The annual dividend adds up to $2.56. At the current price per share of $48.75, this is a 5.25% dividend yield.
Why Does Dividend Yield Vary in Stocks?
There is always a difference in dividend yield among sectors, industries, and even individual stocks in one industry. Even a particular company has a dividend yield that constantly changes. Since dividends are affected by stock prices, the dividend yield fluctuates as stock price changes. As a stock price rises, the dividend yield declines and rises as it falls.
Dividend yields differ within sectors and individual companies. Mature and established companies have stable cash flows and are likely to pay a higher dividend, while high-growth companies pay a lower yield. For instance, Duke Energy Corp. (DUK), a regulated utility, has a trailing 12-month dividend yield of 3.96%, whereas Airbnb, which IPOed in 2020, has none.
Low-growth industries such as telecommunication providers, utilities, integrated oil super majors, and consumer staples usually have high dividend yields. Companies in these sectors may have limited opportunities to reinvest their cash flows, so they allocate a higher portion of their free cash flow to dividends. In some cases, they pay out all their net income as dividends.
In contrast, young companies such as recent IPOs use all of their cash flows on growth. They must invest in sales and advertising, research and development, and capital expenditure. Management focuses on expanding market share and entering into new markets. Growth takes priority, leaving limited allocations for dividends.
Some categories and sectors of stocks generally have higher yields due to their structure and legal requirements. Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), and Business Development Companies (BDCs) are structured such that they are required to pay out most of their income as dividends. The Treasury designates these entities as “pass-throughs,” so they must pass on their net income to shareholders. In return, they don’t pay taxes for income paid as dividends.
A company’s forward and future dividend yield may increase as it grows and commits more of its net income to dividends. Calculating the payout ratio, the percentage of net income paid out by a company as dividends, helps assess the probability of future dividend growth. A low payout ratio may indicate the potential for future dividend increases and thus a higher dividend yield in the future.
Older companies with a tradition of paying dividends might occasionally increase dividends. Thus they may have a higher payout ratio from years of raising their dividends even as their revenue growth decelerates. In contrast, fast-growing businesses that have just initiated their dividends might exhibit a low payout ratio since they reinvest most of their net income to fund growth opportunities.
What Is a Dividend Yield Trap?
A high-dividend yield can be alluring, especially for investors who want an income stream. However, it can be a misleading metric. A stock with a relatively higher yield than peers should raise some red flags. Remember, if the dividend per share is constant, the dividend yield rises as the stock price declines. A stock price may be performing poorly due to declining fundamentals such as falling revenues and cash flows. However, the dividend yield keeps rising, representing a dividend yield trap.
A dividend yield trap is a stock investment offering a high-dividend yield but has execution or growth challenges. These problems result in declining results that weaken the price per share. The underlying business might be declining due to a flawed business model, intense competition, or a material change in industry trends — for instance, the decline of traditional newspapers against online media.
Declining businesses have negative revenue and cash flow trends. Their cash burn also increases as falling revenues fail to cover their costs. As revenues decline faster than expenses and cash flows deteriorate, the total dividend payout might surpass the cash flow generated, making the dividend unsustainable. As a result, management might cut the dividend. Such companies might even take on debt to maintain their already high yield, further exacerbating their poor financial state.
Dividend investors should not consider the dividend yield alone while screening for investments. Researching further to ascertain the strength of the business and the sustainability of dividends is essential. Mature companies with substantial competitive advantages have stable cash flows and can sustain a steady dividend. In contrast, an extremely high yield relative to peers or a payout ratio exceeding net income might indicate a business in trouble.