Learn How To Calculate Dividend Yield
Discovering how to calculate dividend yield is one of the best things a new investor can do because it allows an immediate, back-of-the-envelope comparison to the cash yield you would expect from owning a share of stock to the cash interest coupons you would expect had you selected a bond, instead.
In fact, not only does dividend yield allow you to compare cash yields on a stock investment to an investment in bonds, but it can provide a useful comparison to certificates of deposit, money market accounts, money market mutual funds, or real estate projects, as well.
The process of calculating dividend yield is fairly straightforward, but there are a few tips and tricks I'll pass along that can help you make better sense of the reasons dividend yield matters and how dividends should compare to alternative sources of passive income.
The Definition of Dividend Yield
When a company generates a profit, the board of directors often decides to mail out some of those earnings to the owners. For example, when I originally wrote this article on January 28th, 2014, over the past 12 months, each share of McDonald's Corporation had generated $5.55 in after-tax profit, and the board decided to mail $3.24 per share out to the stockholders in cash. If you owned 100 shares, you would have received checks or direct deposits for $324. If you owned 100,000 shares, you would have received checks or direct deposits for $324,000.
The money that is mailed to the owners is called a dividend.
The dividend yield is a financial calculation that tells you how much money you will earn for every dollar invested in the stock at today's price based on today's dividend rate. (An alternative interesting concept is something known as dividend yield on cost, which we will talk about later.)
How to Calculate Dividend Yield
To calculate the most common form of dividend yield, you take the per share cash dividend - keeping with our McDonald's example from several years ago, it would have been $3.24 - and divide it into the market price of the stock.
When this went to digital press, shares of the cheeseburger empire closed at $94.07. Thus, to calculate the dividend yield we would take:
$3.24 cash dividend
--------- (divided by) ---------
$94.07 stock price
The answer is 0.0344, or 3.44%. This tells you that if you put $10,000 into McDonald's shares, you'd expect to collect $344 in dividends per year at the current rate. If you put $1,000,000 in McDonald's, you would expect to collect $34,400 in dividend income per year at the current rate. The 10-year Treasury bond yield, in contrast, was providing a return of 2.78% at the same time.
Dividend Yield on Market vs. Dividend Yield on Cost
The current dividend yield is only half the story. Unlike bond yields, which are based upon a bond paying a fixed rate of interest for the life of the bond, dividends for most successful companies increase over time. Let's continue using McDonald's as an illustrative case study. Take a look at the dividend it distributed to owners for the past six years prior the time period we just discussed (2013).
Note: If you come across this article at some point in the future, don't worry because there is no need to update the figures as the basic concept behind dividend yield remains the same no matter the year and no matter the specific dividend amounts you uncover in your investment research process:
- 2007 = $1.50 dividend
- 2008 = $1.63 dividend
- 2009 = $2.05 dividend
- 2010 = $2.26 dividend
- 2011 = $2.53 dividend
- 2012 = $2.87 dividend
If you had bought McDonald's stock back in 2007, you've watched your dividends increase each and every year. You're collecting far more than you originally anticipated based on the dividend yield on the purchase date. In fact, during that year, the stock averaged almost exactly $53 per share, so imagine you had bought a single share.
On the day you paid for your stock, you were collecting $1.50 in dividends on a $53.00 stock, which is a dividend yield of 2.83%. Over the past 12 months, you've collected a dividend of $3.24. Comparing that $3.24 to the purchase price instead of the market price, you can calculate something known as "dividend yield on cost". In this case, you're actually earning the equivalent of 6.11% per year on your original investment.
This can serve as a major driver of change in the stock price.
Companies that make their owners rich do so by continually earning more profit. Often, these businesses have some sort of inherent economic advantage, like the Coca-Colas of the world, which can raise prices or expand into new markets.
The truly elite dividend payers on Wall Street, those businesses that have raised their dividend payouts to owners each year, without fail, for 25 years or longer, earn a title allowing them to be called a "Dividend Aristocrat".
McDonald's has expressed a commitment to raising its dividend so much, in fact, that we are now approaching the 40th year in a row that it has sent bigger checks to the stockholders. That puts it in a league of its own among other blue chips on Wall Street. Only a handful of other firms can boast such a sterling achievement.
Update: As I come back and freshen this article on November 27, 2016, I should point out that McDonald's has continued its practice of raising its dividend each year. As a matter of fact, here is the subsequent record:
- 2013 = $3.12
- 2014 = $3.28
- 2015 = $3.44
- 2016 = $3.61
That means our original hypothetical investor who bought the stock at $53.00 per share back in 2007 has now collected a cumulative $26.29. That means he or she has collected 49.6% of the original cash outlay for his or her ownership stake in McDonald's back in the form of dividends.
Looking at it another way (and this is merely an academic tool as the tax treatment is different), think of the net purchase price as being $53.00 - $26.29 = $26.71.
With the dividend expected to approximate $3.80 per share in 2017 - the actual number won't be finalized under the last quarter of next year as McDonald's has a practice of raising its dividend during a fiscal year - our investor is probably looking at a forward dividend yield on cost of 14.2%.
Is it any wonder so many people are enamored with dividends? Imagine McDonald's had gone bankrupt - an almost unthinkable possibility given its financial strength and wide geographic diversification but one that could happen in a remote-probability scenario - and the stock went to $0.
In this case, our investor had that $26.29 in cash he or she collected from the dividends. Though still very real, this means the loss itself wouldn't have been nearly as painful. (In actuality, the stock price is now $120.66 per share as the market has adjusted to reflect the increased underlying profitability that has occurred during this span of time.
This means our investor would have enjoyed not only $26.29 in cash dividends but $67.66 in unrealized capital gains for a total profit of $96.92 on each $53.00 invested. To learn more about this concept, read Focus on an Investment's Total Return Not Capital Gains.)
Some High Dividend Stocks Are Traps Despite Attractive Dividend Yield Calculations
On the flip side of the equation are the dividend traps that ensnare inexperienced investors. These are companies that look like they are going to make you a lot of money by boasting extremely high dividend yields - often many times what the stock market as a whole is offering.
Yet, sophisticated investors are not stupid. They are avoiding the business for a reason. Perhaps there is an enormous law suit that could bankrupt the company. Maybe the financials indicate the dividend is not sustainable and will have to be cut.
One defensive move in a situation like this is to look at the dividend yield of a company relative to others in the industry. If there is a single homebuilder offering a 14% dividend yield, something isn't right. Either they are in financial trouble, there was a one-time special dividend that won't be repeated, or there is some other factor that you will need to research; a stock quote alone won't suffice.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.