A dividend is a portion of a company’s profit that is paid back to shareholders. In most cases, companies that issue a dividend are financially stable. Many of these companies are in mature industries and have stable, predictable revenue and earnings. Utility stocks and consumer discretionary stocks are good examples of companies that traditionally pay dividends.
However, although dividend stocks are traditionally lumped into the “value” category, many of these companies can generate significant capital growth, particularly in a bull market. One of the distinctions, however, is the ability of these companies to pay a dividend in a bear market. This can be considered a kind of reward for investors who may otherwise not be seeing a lot of growth.
Of course there are many dividend stocks to choose from. One way to evaluate one company from another is by looking at its dividend yield. In this article, we’ll review the definition of dividend yield, explain how to calculate it. And more importantly review why bigger is not always better.
What is a dividend yield?
Dividend yield is a calculation of the amount (in dollars) of a company’s current annual dividend per share divided by its current stock price:
Current annual dividend per share/current stock price
For example: A company that pays $2 in dividends on an annual basis with a stock price of $60 has a dividend yield of 3.33%. It’s that simple. But in that formula there is a lot of room for variance. And that could affect how an investor should feel about a particular dividend.
The key word on both sides of the equation is “current”. A dividend yield is very fluid. And although a company has very little control over its stock price on a given day, it has complete control over its dividend.
Companies typically pay dividends quarterly (i.e. four times per year) or annually (once a year). When a company delivers its earnings report to shareholders, it usually provides guidance about the direction of the dividend.
If the company is expecting growth in earnings and revenue, they may project a dividend increase. If the company is expecting slowing and/or declining earnings and revenue, they may project keeping the dividend the same. In extreme economic downturns such as the financial crisis of 2007-2008 and more recently the Covid-19 pandemic, companies may drastically cut or briefly suspend its dividend.
Is a higher dividend yield always better?
At first glance you might think so. But the answer is sometimes yes and sometimes no.
Let’s say an investor is comparing two companies within the same sector, like two utility stocks for example. In this case, if everything else is relatively equal between the companies, then it’s reasonable to presume that the company with a higher dividend yield is a better investment.
But to check if the presumption is correct, investors need to look at both sides of the calculation.
How does stock price affect dividend yield?
First let’s talk about the company’s stock price.
In our example above, Company A has a dividend yield of 3.33% based on an annual dividend of $2 per share and a share price of $60 per share. Let’s say you’re comparing that company with Company B that is paying $1.50 per share annually as a dividend. This company has a stock price of $50. Their yield is 3%
However, if Company A’s share price rises to $69 per share, the dividend yield will drop to 2.8%. Does this mean that it’s now better to buy shares of Company B? Not necessarily. In fact, if Company B’s stock price hasn’t moved over the course of a year, and Company A’s stock price has increased by 15%, the better investment for total return will be Company A.
How does dividend per share affect dividend yield?
Going back to our example where Company A has a dividend yield of 2.8%. What if Company B’s stock price did not change? However, Company B was able to increase its annual dividend from $1.50 to $1.75. Now its dividend yield is 3.5%.
This means investors will have to look at other factors to decide which company’s stock is better to own. For example, maybe analysts are projecting that Company A will raise its dividend later in the year. That would mean that the difference in yield between Company’s A and B may be insignificant.
The examples above were given simply to help you understand that a dividend yield is very fluid and can change daily based on factors outside of the company’s control. One thing that can help shape your perception of a company’s dividend yield is its historical yield.
Once a company starts to issue a dividend, they will usually give it a high priority. This is because once investors begin to expect a dividend, cutting it or suspending it (aside from extreme circumstances) may cause investors to question the health of the company.
Beware of the yield trap
A dividend yield trap occurs when the stock of a company falls faster than its earnings. This will make its yield look more attractive than it really is. Here’s why it’s a trap. Let’s say you buy the stock at its low price and then the company cuts its dividend. Now, investors may start to sell off even more, lowering the share price which means you’ve lost capital growth and are looking at a lower yield.
This is not the fault of the company. However, in rare cases (although maybe not as rare as they should be), a financially troubled company will deliberately try to jack up their yield so that investors will buy the stock.
Dividend payout ratio is equally important
Many investors, in addition to looking at a company’s dividend yield will also look at their dividend payout ratio. The payout ratio is the amount of a company’s net income that goes towards dividends. Analysts will examine a company’s payout ratio based on one or more of the following metrics:
- Trailing 12 months of earnings (TTM)
- Current year’s earnings estimates
- Next year’s earnings estimates
- Based on cash flow
Like the company’s dividend yield, a good payout ratio depends on many factors, one of which is the sector that a company performs in. If one company’s payout ratio is significantly higher or lower than another company’s in the same sector it merits further investigation.
The bottom line on dividend yield
In general, when a company pays a dividend, analysts consider that to be an indication that the company has good fundamentals. In good (and sometimes rough) economic conditions, these companies have solid balance sheets. That’s because many of these companies are in defensive industries. This means demand for its products are generally stable regardless of market conditions.
When a company increases its annual dividend for at least 25 consecutive years, it becomes part of a club known as the dividend aristocrats. These companies are generally considered safe investments because they have been able to issue regular dividends in both good and bad financial conditions.
However as we’ve shown, a dividend yield must be looked at in light of a company’s total financial picture. Sometimes a company may cut its dividend so as to pay off some long-term debt or shut down non-profitable parts of its business. In this case, analysts may see a dividend cut as a prudent move.