Analyzing financial ratios can be a great way to dissect the fundamental picture of companies of interest. If you’re going to add an investment to your portfolio, it’s important to know what you’re getting into. One of the best ways to tell how a company is doing is by looking at its dividend yield – meaning, how well the stock price is doing compared to the dividend paid to investors.
Despite comprising a large majority of an investment portfolio’s return, yield has been harder and harder to come. This is largely due to the current global interest rate environment. However, in bad markets, dividends may be the only source of returns for investors.
Furthermore, as it relates to equities, dividend yielding companies can serve as a buffer against periods of steep portfolio drawdown.
This article will help you understand what dividend yield is, how to calculate it, and where you can find information online.
Before we continue, FinancialProfessional wants to remind you that any information in this article serves as educational material only. It is not meant to be taken as investing advice. Before making financial decisions, you should look at your personal situation (and maybe consider a licensed financial professional).
What is Dividend Yield?
Yield simply refers to the amount of interest offered by an investment. In the case of dividend-paying stocks, yield refers to the annual dividend divided by the company’s current share price.
For example, if a company pays out a $0.25 quarterly dividend ($1 annually) and is currently trading at $10, it would have a dividend yield of 10%.
Here’s the math behind that calculation:
- $0.25 quarterly dividend x 4 quarters in a year = $1.00 annual dividend
- $1 annual dividend / $10 current share price = 0.1
- 0.1 x 100% = 10%
Dividends are attractive because they serve as a form of passive income. This can be used to either reinvest back into the portfolio or remain as cash. Alternatively, it can be withdrawn and used to supplement other sources of income that the investor may have.
The higher a company’s annual dividend is compared to its share price, the higher the dividend yield. When stocks take a beating their yields tend to go up, as long as the dividend payout does not change.
This is what investors tend to mean when they say “dividends have gone on sale.” You are essentially receiving the same amount of yield, but for a lesser price.
Relying On Yield Alone
When owning individual companies, it is imperative that you do your research as to what’s going on with the company in its entirety.
Ratios such as P/E, EPS, debt to equity, dividend yield, etc., are helpful for comparing a company to industry competitors. However, by themselves, these ratios do not always tell the whole story.
The Value Trap
Falling into the “value trap” is a common mistake amongst investors that rely solely on ratios. Without truly understanding what a company is doing in order to increase its earnings and overall value to its shareholders, you can’t make a well-informed investment decision.
Value companies are known for being more mature relative to their growth counterparts. Mature companies are much more likely to pay out dividends compared to younger, more aggressive companies. Typically, the younger a company is, the more aggressively it’s trying to scale operations.
When relying on yield alone for the basis of their portfolio construction, investors may miss out on precious capital appreciation on offer by growth companies. This is exactly what the value trap tends to hint at.
The Dividend Payout Ratio
Another thing to be aware of when it relates to high yielding companies is the firm’s dividend payout ratio. This measures the proportion that a company pays out in dividends relative to its actual earnings. If a company has an extraordinarily high dividend yield, there is a chance that it may have an unhealthy dividend payout ratio – meaning, they are not putting their money where their mouth is (or should be).
Why is a grossly high payout ratio unattractive? Think about it.
Companies that use earnings primarily to pay out dividends forgo using that money to scale its operations via capital expenditures. Examples of such investments include new facilities, research and development, and the like. Because the share price represents the denominator in the dividend yield equation, a very high yield could be representative of a company that’s going through a difficult time and has fallen out of favor, for good reason.
Your job is to investigate why the yield appears to be so high and what’s really going on under the hood of a company.
As it relates to the payout of dividends, you must remember that dividends are subject to change at any time.
The beginning of the 2020 “Oil Price War” actually forced some companies to slash their dividends substantially in order to combat the pressure they felt from the decrease in oil prices.
On the flip side, companies can also increase their earnings. The S&P 500 dividend aristocrats is a group of companies well-known for their strong dividend history.
In short, you must always be aware of the fact that dividends can and will change. You should account for that in your research and strive to understand the meaning behind a company’s history of dividend yield fluctuations.
Not All Dividends Are Made Equal
When comparing the dividend yield of one company to another, it’s important that you compare apples to apples – meaning, you should compare the yield of a company in one industry to the yield of another company in the same industry. As a rule, different sectors and industries have different standards for how they pay out dividends.
For instance, utilities, communications, and consumer staples are sectors that have been known historically for their dividend payouts.
These industries tend to have steady, reliable cash flows that allow the firms to consistently reward shareholders with a dividend payout.
Other sectors have been known to pay out less in the way of dividends. Younger industries, such as technology, tend to be more focused on aggressively growing given the fierce competition in their respective industries.
As an investor, you should be looking at the fundamentals of a firm in the context of its industry peers. This helps ensure you are making a decision using the appropriate benchmark.
For More Information…
There are plenty of sources where one can find information on a company’s dividends and financial ratios.
There are plenty of great websites like Yahoo Finance, MarketWatch and FinancialProfessional, which include the figures required to calculate the yield of individual companies.
In fact, if you do a quick Google search, dividend yield is one of the first metrics that comes up.
If you are considering an equity fund, such as a mutual fund or ETF, you can easily find the information via the fund’s Fact Sheet or Prospectus.
As always, make sure the data you are using is as up to date as possible and comes from a reliable source.
How Can Dividend Yields Serve You?
Dividend paying companies can be a big value-add to a portfolio, especially for investors in the asset accumulation phase that are looking to reinvest the income back into their portfolio.
The dividend yield can serve a solid guidepost as to how much return you’ll be getting from dividends alone.
Bear in mind that yield is only a part of the total return equation. Capital appreciation is very important, especially for investors that are in need of growth early on.
As always, do your research prior to owning a company or fund. Make sure that you compare the metrics of the fund or company to the appropriate benchmark.
Have questions on dividend yield? Let us know!