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. However, if you're a value investor or looking for dividend income, a couple of measurements are specific to you.
One of the telling metrics for dividend investors is dividend yield, which is a financial ratio that shows how much a company pays out in dividends each year relative to its share price.
Dividend Yield Formula
Dividend yield is shown as a percentage and calculated by dividing the dollar value of dividends paid per share in a particular year by the dollar value of one share of stock.
Dividend yield 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% ($1.50 ÷ $25).
Yields for a current year can be estimated using the previous year’s dividend or by multiplying the latest quarterly dividend 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.
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. Company ABC’s dividend yield is 5% (1 ÷ 20), while XYZ’s dividend yield is only 2.5% (1 ÷ 40). Assuming all other factors are equivalent, an investor looking to use their portfolio to supplement their 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.
Be Aware of Too-High Yields
Keep in mind that paying out high dividends can also cost a company 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, a scenario often referred to as a "value trap." Find out why the stock's price has dropped. If the company is 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, for instance. This type of situation has no quick fix, but other issues might. The company could rebound—even sooner rather than later—so it's important to understand what might be causing declines.
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, to lure investors. It's a good idea to track dividend yields over time to gain a clearer focus on what's going on.
The Bottom Line
A good dividend yield can be a good measure when evaluating stocks for investment purposes. But it doesn't always mean a strong company. Look beyond the number at just one moment in time and be sure to look at the industry and the company's dividend yield over an extended period. You want to know there's some consistency and it's not just a one-time fluke.