Understanding Dividend Yields: A Guide for Investors

Dividend investing is a popular choice for investors who want regular income. One key concept in dividend investing is dividend yield. Here, we explore dividend yields, including what they are, how they are calculated, and why they matter.

What is a Dividend Yield?

A dividend yield is a financial ratio that shows how much a company pays out in dividends each year relative to its stock price.¹ In other words, it is a way for investors to measure the income they can expect to earn from an investment in a stock. The dividend yield is expressed as a percentage, making it easy to compare across different companies and sectors.

Calculation of Dividend Yield

The dividend yield is calculated by dividing the annual dividends per share by the price per share and multiplying the total by 100 to obtain a percentage.

For example, if a company pays an annual dividend of $2 per share and its current stock price is $40, the dividend yield would be:

(2 divided by 40) × 100 = 5%

This means that for every $100 invested in the stock, an investor can expect to receive $5 in yearly dividends.

Why Dividend Yields Matter

Dividend yields are an important metric for several reasons:

Income Generation
For many investors, especially those on a fixed income, such as retirees, the primary appeal of dividend stocks is the regular income they provide. A higher dividend yield can mean more income.

Investment Comparison
Dividend yields allow investors to compare the income-generating potential of different stocks. This can help in selecting stocks that align with their income goals.

Market Sentiment
Dividend yields can also provide insight into market sentiment. A very high dividend yield might indicate that a stock is undervalued, but it could also signal that the company is in trouble and that the stock price has fallen significantly.

Factors Affecting Dividend Yields

Several factors can influence a company's dividend yield, including:

Stock Price Fluctuations
Since the yield is based on the stock price, any changes in the stock price will affect the yield. If the stock price falls and the dividend remains the same, the yield will increase, and vice versa.

Dividend Policy
A company’s policy on paying dividends can impact the yield. Some companies prioritize returning profits to shareholders through dividends, while others reinvest profits back into the company.

Economic Conditions
Broader economic conditions can affect dividend yields. During economic downturns, companies might reduce or suspend dividends to conserve cash, leading to lower yields.

Types of Dividend Yields

Dividend yields can be classified into several types, which can provide different perspectives for investors:

Forward Dividend Yield
A forward dividend yield is based on the expected future dividends.² It uses the forecasted dividend payments over the next year, providing a forward-looking perspective. The forward dividend yield is calculated by dividing a year’s worth of future dividend payments by a stock’s current share price.

Trailing Dividend Yield
A trailing dividend yield is based on actual dividends paid over the past year. It gives a historical view of dividend payments. Be aware that using a trailing dividend number can make the yield too high or too low if the dividend has recently been cut or raised.¹

Current Dividend Yield
This is the most commonly used yield. It’s calculated using the current annual dividend and the current stock price.

Dividend Reinvestment Plans (DRIPs)

One way to invest in dividends is to choose a dividend reinvestment plan (DRIP). DRIPs allow investors to reinvest their dividends in additional shares of the stock, potentially increasing their investments over time.³

When investors enroll in a DRIP, the cash dividends they earn from holding the company’s stock are not paid out as cash. Instead, these dividends are used to purchase additional shares of the company’s stock. This process is automatic and continues as long as the investor remains enrolled in the plan.

Understanding dividend yields is key to building a portfolio that generates regular income. By knowing how to calculate and interpret dividend yields, investors can make informed decisions and select stocks that align with their financial goals.