There are various parameters that investors and money managers use when picking stocks for their portfolios.
Some of them include Free cash flow, price to book ratio, P/E ratio, etc. One of the measures you’ll see when evaluating stocks that pay a dividend is “yield.”
So, what is dividend yield and how can you use it to select stocks that would optimize gains from your portfolio?
What is Dividend Yield?
Dividend yield is the amount of money a firm pays out in dividends per dollar invested each year.
It is the financial ratio that gauges the amount of cash dividends paid out to shareholders in relation to the market value per share.
Dividend yield is calculated by multiplying the dividend per share by 100 and dividing the result by the market price per share. For example, if a stock has a dividend yield of 7% and you own $1000 of its stock, you’ll receive $70 in annual dividends or $17.50 in quarterly installments.
Dividends are usually paid out depending on the number of shares you possess, rather than the value of those shares. Dividend yields change as a result of this and are affected by current stock prices.
Many stock research programs will compute dividend yield for you, but you can do it yourself as well.
Dividend Yield Formula
You can use the dividend yield formula to calculate a stock’s dividend yield if this information is not made public or you want to determine the most recent dividend yield percentage. Divide the annual dividends paid per share by the share price per share to calculate dividend yield.
Dividend Yield = Annual Dividends Paid Per Share / Price Per Share
For example, if a company paid out $5 in dividends per share and its shares currently cost $100, its dividend yield would be 5%.
2 Ways to Find a Company’s Annual Dividend Payout
Annual report
The yearly dividend per share is normally listed in the company’s most recent full annual report.
The most recent dividend distribution. Divide the most recent quarterly dividend payout by four to get the annual dividend if dividends are paid out quarterly.
Trailing dividend method
For a more nuanced picture of stocks with changing or inconsistent dividend payments, you can add up the four most recent quarterly dividends to get the annual dividend.
Albeit, keep in mind that dividend yield is rarely consistent and may vary further depending on which method you use to calculate it.
Read this next: What’s a Dividend Exchange Traded Fund & How to Choose the Best One For You
The Importance of Dividend Yield
Understanding dividend yield is important because it may help you figure out which stocks will give you the best return on your dividend investment. However, there are a few additional advantages to think about. Let’s have a look at some of them.
Helps with stock comparison
If you’re looking for a way to supplement your income, compare and select stocks depending on which provide the highest dividend per dollar invested. Because corporations’ stock values fluctuate greatly, the absolute dividend amount you receive per share is a less useful indicator.
Companies X and Y, for example, both pay a $2 annual dividend per share. Company X’s stock, on the other hand, is $50 per share, whereas Company Y’s stock is $100 per share. Company X has a dividend yield of 4%, whereas Company Y has a yield of only 2%, implying that Company x is a better investment for income investors.
Used to indicate financial standing
When a firm decides to increase its payout—and thus its dividend yield—investors can assume that the company is doing well because it can afford to pay out more of its profits to shareholders.
In general, more established companies tend to pay regular dividends and have higher dividend yields. On the other hand, newer, faster-growing companies tend to reinvest their profits in order to grow, rather than pay a dividend.
Dividends increases portfolio returns
Your portfolio benefits from reinvesting your dividends rather than cashing them out every year or quarter.
Compounding effects can dramatically increase your earnings over time.
Some Hidden Dangers of Stocks With High Dividend Yields
A high dividend yield isn’t always indicative of a good investment. In fact, an unusually high yield could be a warning sign. This could happen for a variety of reasons:
Falling stock price
If a stock’s price has dropped dramatically but its dividend hasn’t been slashed yet, the yield may look to be high. Consider a business with a stock price of $60 and a $2 annual dividend per share. If the stock drops to $20, the dividend yield nearly triples to around 10%.
This yield may appear to be quite attractive at first glance, but closer analysis reveals that the company is in jeopardy because its stock price has decreased dramatically. This could indicate a dividend cut or termination in the near future.
To attract new investors
The company may also be attempting to woo investors with a high dividend payment.
To attract new investors, several corporations aim to improve their stock values by increasing the dividend. Some investors may acquire shares because of the high dividend yield, causing the stock price to rise.
However, if the company isn’t financially solid and can’t afford to maintain the larger dividend payments, this dividend payout—and greater stock value—might not last.
With this in mind, it may make sense to seek companies with lower but consistent dividend yields or to invest solely in high-dividend corporations with strong financials and pay rates comparable to those in their industry.
The 5 Best Dividend Yield Sectors
If you’re looking for sectors with high dividend yield stocks, it is advisable to look towards dividend aristocrats.
These are stocks that have consistently raised their dividend payouts over decades. Alternatively, you can search for stocks in the underlisted sectors:
1. Utilities
In general, electricity and water suppliers offer high, consistent dividends.
Even natural gas suppliers have provided relatively high, stable dividends in the past.
2. Consumer staples
Companies that offer consumer staples often have long-standing dividend programs.
In fact, many dividend aristocrats are consumer staples companies.
3. Telecommunications
Companies that provide telephone and internet services often offer fairly high dividends.
4. Energy
Energy companies usually pay bigger dividends.
This is due in part to the fact that many are master limited partnerships (MLPs), which must distribute all profits to shareholders in order to maintain their tax-favored status.
5. Real estate
Similar to MLPs, real estate investment trusts (REITs) must distribute almost all of their profits to shareholders as dividends to keep their tax status.
This can lead to much higher than average dividend yields.
Photo by Sasun Bughdaryan on Unsplash
