There are plenty of financial ratios that can be used by investors to help determine the value of a stock. Sometimes these calculations can tell us when it is time to buy a stock, while other times they signal it is time to sell a position. There are plenty of commonly used calculations, such as the price to earnings ratio, which can be used to evaluate any type of security. In other cases there are specific ratios geared towards a certain investment strategy, like dividend investing.
One of the most widely used financial ratios to evaluate dividend paying stocks is referred to as the current yield. The dividend yield can help give investors clues about the potential return on investment they may expect to get by initiating a position.
What Does Dividend Yield Mean?
A dividend yield calculates the percentage a company pays out in dividends compared to its share price. The ratio measures the amount of annual income an investor can expect to receive for each dollar that is invested. For example, a company that has a 5% yield would mean the investor has the potential to earn 5% back on their investment, for each dollar they invest.
The nice thing about using the current yield is that it can be compared to other high yield investments, including savings accounts and CDs. For example, an investor could compare investing in a stock against the return on investment for a certificate of deposit. This ratio can then help the investor weigh the risks of each type of investment compared to the potential return on investment.
How to Calculate a Dividend Yield
A company’s current yield can be found on most financial websites. Online discount brokers also provide this ratio when investors open an account. Since this data can easily be accessed for free online, it is no longer necessary to calculate this ratio by hand.
While locating a current yield for a company is easy to find, it can help to understand what makes up the calculation. Here is the equation -
Yield = Annual Dividends / Current Share Price
Using the equation above, let’s calculate the dividend yield of a hypothetical scenario. The first step is to find the annual dividend of a stock and its current price per share. If you determine that a company has paid out $2 in the past 12 months in dividends and the current share price of the stock were $50, then the current dividend yield would equal 4.0% (see equation below).
Yield = $2 / $50 = .04 or 4%
If the share price suddenly rises to say $55, then the dividend yield would change as well. Assuming the company did not lower or raise their dividend, investing in the same stock at $55 would actually lower the return on investment. Instead of earning a 4.0% yield, an investor would only earn 3.6% (see equation below).
Yield = $2 / $55 = .036 or 3.6%
When the share price goes down, the dividend yield would fluctuate in the opposite direction. For example, if the stock dropped from $50 per share to $45, then investors would see a rise in the potential return on investment (assuming the dividend is unchanged). The yield would rise from 4.0% to 4.4% as the investor is theoretically getting more value for their dollar (see equation below).
Yield = $2 / $45 = .44 or 4.4%
Analyzing a Dividend Yield
While the current yield is a useful ratio to identify the best dividend stocks, it can be very misleading. First, this calculation can grossly over estimate the return on investment. For example, a dividend stock that is tanking in the market may have a current yield close to 10%. To the uneducated investor, this may seem like a great investment opportunity. In reality, a rising yield is probably a direct sign of an imminent dividend cut.
Another downside of relying solely on the current yield is that it doesn’t provide a good representation of stocks you already own. For example, if you entered a position with a current yield of 4%, your return on investment is probably not the same. Because the yield follows the stock movement, it can only measure the current share price against the past dividend payout.
An alternative ratio that many dividend investors use is the yield on cost, which tracks your personal return on investment.
Final Thoughts
Using the current yield of a stock can be a great way to narrow down investment options for a income investor. Calculating the yield can provide useful information on just how much is paid out in dividends by a company compared to its share price. Unfortunately, using the dividend yield cannot be used alone to evaluate income producing stocks. Factoring other ratios like the yield on cost and dividend growth rate with the current yield can provide a better idea of how healthy a particular income stock is.
How do you use the dividend yield ratio? What other financial ratios do you use to evaluate a dividend paying stock?
Related posts:
- How to Calculate the Yield on Cost of a Dividend Stock
- How to Select Dividend Paying Stocks by Looking at the Current Yield
- High Yield ETFs – An Alternative to Dividend Paying Stocks?
- How to Calculate and Use the Dividend Payout Ratio
- How to Find the Top Dividend Stocks
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