A dividend is the distribution of part of a publicly-traded company’s profits to its shareholders. Companies may pay dividends on a monthly, quarterly, semi-annual, or annual basis. Dividends can come in the form of cash payments or shares and are determined by the company’s board of directors.
Typically, it is large, established companies with steady profits which pay dividends. Companies paying dividends are often in the financial, energy, healthcare, pharmaceuticals, telecommunication, consumer goods, information technology, real estate, and utility sectors. Not all companies pay dividends and new companies usually prefer to reinvest profits into their growth. In this article, we’ll explain the meaning of dividend yield, which is an important figure to understand for investors in dividend-paying stocks.
What is Dividend Yield?
Dividend yield shows how much a company pays its shareholders in dividends annually per dollar invested. It reflects how much an investor will earn aside from any capital gains in the stock.
The dividend yield figure is expressed as a percentage. For example, if you own $20,000 of stock of a company with an annual dividend yield of 5%, you would receive $1,000 in dividend payments for the year.
It is a helpful metric because two companies may have the same dividend payout per share but different dividend yields. Imagine company A pays a dividend of $2 per share and is trading at $40 and company B also pays a dividend of $2 per share and is trading at $60. Company A has a greater dividend yield due to having a lower stock price.
Dividend yields can change and have an inverse relationship to the stock price. The yield will rise when the price of the stock falls and fall when the price of the stock rises. Dividend yield allows individuals to compare the dividend payments of different companies and better evaluate them as investments.
How to Calculate Dividend Yield?
Dividend yield formula:
Dividend Yield = Annual Cash Dividend per Share / Market Price per share * 100
How does dividend yield work?
Let’s look at the following example. Imagine that a stock with a price of $200 has an annual dividend of $5 per share. The dividend yield for that stock would be 5/200 x 100 = 2.5%
There are several different methods for estimating the dividend per share of a company for a current year.
The company’s previous full annual report will typically list the annual dividend per share. The most recent dividend can also be used and multiplied by the number of times the dividend is paid out per year. For example, taking the most recent quarterly dividend and multiplying it by four. Alternatively, to take into account changing dividends, an investor can add up all the dividend payments over the prior year.
Dividend Yield Pros and Cons
- Reliable stream of passive income, even during periods of market instability. Dividends get paid whether the market is moving up or down. They provide a form of insulation from the volatility and unpredictability of the market. Dividends create a situation where you are getting paid to wait for your stock market investment to appreciate.
- A largely dependable source of income. Procter & Gamble (PG) has paid a dividend every year since 1891. In addition, well-established companies that pay dividends usually increase their dividend payouts over time. For example, in April of 2021, IBM increased its quarterly dividend by a cent to $1.64 per share, marking 26 consecutive years of rising dividends. Making long-term investments in high-quality companies paying dividends is arguably a better strategy than trying to time the market, which is notoriously difficult.
- Hedge against inflation. As prices are lifted by inflation, profits are also boosted, and companies can afford to increase their dividend payments.
- Dividends can be reinvested for compounding returns. By reinvesting dividends in more shares, you increase your potential earnings from future dividends, which in turn allows you to buy even more shares. The powerful force of compounding was recognized by Albert Einstein, who said: “Compound interest is the eighth wonder of the world.”
- There are tax benefits associated with earnings from dividends. For example, in the United States, the IRS allows qualified dividends to be taxed at a lower capital gains rate.
- Earnings may be somewhat capped. Dividend-paying stocks typically see less price appreciation than growth stocks. Growth investors focused on young, small companies have the potential for earning unusually large gains. So while dividend-paying stocks can provide healthy and consistent gains, they are unlikely to generate the massive returns that would have been achieved for example by buying Tesla (TSLA) in 2011.
- Dividends that are being paid to investors limit the potential growth of a company and subsequently hinder the stock price from rising. The money that is paid to shareholders can no longer be used to reinvest in the company itself.
- Companies can cut or eliminate their dividend payments at any time. An extreme example is the financial crisis of 2008, when many major banks either reduced or cut their dividend payouts entirely. When evaluating a stock, it is advisable to check the history of the dividend yield for stability and consistency.
- Investors should be careful to not be lured into buying a stock based on a high dividend yield alone. Dividend yield will rise as the price of a stock falls. If the price of the stock is in a downtrend it could continue to fall and on top of that, there is the risk that the dividend could be cut or canceled.
- Earnings are taxed twice by the government. As part owners of the company, shareholders pay a first round of tax when the company pays taxes on its earnings. The second round of tax is based on the dividend earnings received by shareholders, from the company’s after-tax earnings. In this way, there is a double taxation.