Disclosure: This article is written for entertainment purposes only and should not be construed as financial or any other type of professional advice.
One of the measures you’ll see when evaluating stocks that pay a dividend is “yield.” A friend gets excited when a stock’s dividend yield is 2% or higher. However, I’m sometimes skeptical of a high yield.
Why do we react differently? My friend wants to hold stocks for their dividend payments, cash deposited into her account quarterly. I like to hold stocks for their potential to thrive over the long term plus grow in share price; in this way, I can generate income by selling shares at appropriate times. Lately, though, I’ve been more interested in dividend-paying stocks as I seek to generate passive income with minimal need to buy and sell shares.
Yield contains layers of meaning to me.
What Dividend Yield Means
The first and most obvious meaning of dividend yield is its payout as a percentage of the invested amount. This percentage is comparable to an interest rate. For example, if you buy a company’s stock when its share price is $200 and receive $2 in dividends, this deal is similar to receiving 1% in interest on a $200 balance in a savings account. So, if you look at a single moment, the dividend yield is equivalent to the interest yield.
But, dividend yield changes as share prices change. Stock prices change daily, so the yield changes daily. This fluid situation means that the yield is reflective not only of the dividend amount but also of the share price. A higher share price results in a lower yield; and a lower share price results in a higher yield. For example, if the stock price of the theoretical company mentioned earlier increased from $200 to $300, the yield declines to 0.67% ($2/$300). If the price falls to $100, the yield increases to 2%.
So, dividend yield reflects a company’s stock valuation as well as its dividends paid to shareholders. A higher yield can indicate a lower-than-usual valuation and a low yield represents a higher-than-usual valuation. A low valuation can mean a bargain but it can also mean that the company offering the dividends isn’t doing as well as its lower-yielding counterparts.
How to Calculate Dividend Yield
Dividend yield is calculated using two numbers: the annual dividend payments and the stock price. Divide the dividends by the price and the answer is the yield. Using the earlier example, if a stock is selling for $200 and the dividend is $2.00 per year, then the yield is $2.00/$200.00 = 1% yield.
Generally, dividends are paid on a quarterly basis. So, be sure to use the annual number, not the quarterly one. Further, the stock price can vary over time (as can the dividend but the price is usually more volatile), so the yield is constantly changing. However, yields could be based on year-end numbers rather than the current prices.
Overviews of individual stocks on investing websites and brokerage firms often show the dividend yield along with annual dividend amounts and share prices. So you can quickly get this number and do your own calculations. Today, at Market Watch, I see that Mastercard’s (MA) dividend yield is 0.78%. Its share price is $205.96 and its dividend is listed as $0.40. The dividend mentioned is its quarterly payout so first I multiply the dividend by 4 quarters, $0.40 x 4 = $1.60. To get this yield, divide $1.60 by $205.96 (1.06/205.96) = 0.78%. (Disclosure: I’m long on MA.)
How Much Weight to Give Dividend Yield
The dividend yield is a fast and simple way to evaluate a dividend-paying stock. If you’re confident about the long-term prospects of a company (through an analysis of its balance sheet and other measures), then a high yield may carry the most weight in your consideration.
Further, the low valuation that contributes to a higher yield may indicate that the stock is a bargain at the time. This thought process underlies the Dogs of the Dow strategy.
It’s important to note that dividends aren’t guaranteed the way interest payments on FDIC-insured bank accounts are. Any company declaring and paying dividends can stop payments at its discretion. Sure, it’s a big deal to stop payments. This move signals a change in the company’s expectations and the use of extra cash.
So, dividend yield should be just one of the ways to evaluate the attractiveness of a company and its shares.
When you buy a dividend-paying stock, you position yourself to generate an income stream in two ways: 1) dividends distributed by the company on a periodic basis and 2) money from the sale of shares, hopefully at a gain through price increases. What’s particularly attractive about these stocks is that you can make money even when the share price fluctuates.
How do you evaluate dividend-paying stocks?