Understanding Dividend Yield

Dividend yield is a financial ratio

Stock figures and bridge
••• John W Banagan/ Photographer's Choice/ Getty Images

Not all the tools of fundamental analysis work for every investor on every stock. If you're looking for high-growth technology stocks, they're not likely to turn up in any stock screens you might run looking for dividend-paying characteristics.

If you're a value investor, however, or if you're looking for dividend income, a couple of measurements are specific to you. One of the telling metrics for dividend investors is dividend yield.

Dividend yield is a financial ratio that shows how much a company pays out in dividends each year in relation to its share price.

Dividend Yield Formula 

Dividend yield is shown as a percentage. It's calculated by dividing the dollar value of dividends paid in a certain year per share of stock held by the dollar value of one share of stock. It equals the annual dividend per share divided by the stock's price per share.

For example, if a company’s annual dividend is $1.50 and the stock trades at $25, the dividend yield is 6 percent: $1.50 / $25 = 0.06.

Yields for a current year can be estimated using the previous year’s dividend yield or by using the latest quarterly yield, multiplying it by 4, then dividing by the current share price.

Understanding Dividend Yield

Dividend yield is a method used to measure the amount of cash flow you're getting back for each dollar you invest in an equity position. In other words, it's a measurement of how much bang for your buck you're getting from dividends. The dividend yield is essentially the return on investment for a stock without any capital gains. 

Here's a dividend yield example from Investopedia:

"Suppose company ABC's stock is trading at $20 and pays yearly dividends of $1 per share to its shareholders. Also suppose that company XYZ’s stock is trading at $40 and also pays annual dividends of $1 per share. This means that company ABC’s dividend yield is 5% (1 / 20 = 0.05), while XYZ’s dividend yield is only 2.5% (1 / 40 = 0.025). Assuming all other factors are equivalent, then, an investor looking to use his or her portfolio to supplement his or her income would likely prefer ABC's stock over that of XYZ, as it has double the dividend yield."

Investors who need a minimum cash flow from their investments can secure it by investing in stocks paying high, stable dividend yields.

Older, well-established companies usually pay out a higher percentage in dividends than younger companies, and older companies' dividend history is also generally more consistent.

Can Yields Be Too High?

Keep in mind that paying out high dividends can also cost a company in growth potential. Every dollar a company pays out to its shareholders is money that the company isn't reinvesting in itself to make capital gains. Ask yourself why a yield might be high; then investigate a little. 

Sometimes a high dividend yield is the result of a stock's price tanking. The yield will mathematically rise because the price is dropping. This type of scenario is often referred to as a "value trap," so buyer beware. Find out why the stock's price has dropped. Is the company suffering financial woes? You might want to steer clear of this investment, but do your homework to be sure. 

Background influences such as an ailing economy can be an influence as well. Homebuilder stocks plummeted during the 2009 recession. This type of situation has no quick fix, but some other issues might and the company could rebound—even sooner rather than later.

You'll also want to be aware of the type of company you're investing in, because some dividend yields are unnaturally high. Master limited partnerships (MLPs) and real estate investment trusts (REITs) are two examples. These types of companies are required by law to distribute a very significant percentage of their earnings to shareholders, resulting in higher dividend yields.

This doesn't necessarily make REITs and MLPs bad deals, however. Some dividend investors love them. 

Finally, some companies manipulate their growth costs, at least temporarily, in an effort to lure investors. A good idea is to track dividend yields over time to gain a clearer focus on what's going on.