Understanding the Dividend Yield on a Stock
Dividends can be cut and yields can change rapidly
A stock's dividend yield tells you how much dividend income you receive in comparison to the current price of the stock. Buying stocks with a high dividend yield can provide a good source of income, but if you aren't careful, it can also get you in trouble.
To be successful at investing in dividend-paying stocks, you must understand the relationship between the share price and the dividend yield. The first step is knowing how to calculate dividend yield, then, you must familiarize yourself with the pitfalls of those calculations.
Calculating the Dividend Yield on a Stock
The formula for calculating a dividend yield is relatively simple, just divide the annual dividend payments by the stock price. Here's an example scenario:
- You buy stock for $10 a share
- The stock pays a dividend of $0.10 per quarter, which means for every share you own, you will receive $0.40 per year
- Divide $0.40 by $10, giving you 0.04
- Convert 0.04 into a percentage
- This stock has a 4% dividend yield
Which Companies Issue Dividends?
No company is required to issue dividends, so there isn't a set rule about which companies will issue dividends and which companies won't. Even if a company has issued dividends in the past, there's no requirement that they maintain those dividend payments. That said, some trends can point investors in the right direction.
Dividends occur when a company shares profits directly with shareholders. That means well-established blue-chip companies with a steady history of profit growth are more likely to issue dividends than start-up growth companies that are rapidly expanding.
New companies need all the money they can get to fund their expansion. This is especially true for start-ups that haven't yet managed to turn a profit. For this reason, they don't usually pay a dividend. Investors who buy stock in these kinds of companies are anticipating an increase in stock price, rather than steady income from dividends. Companies that no longer expect rapid growth use dividends to entice investors to hold the stock.
Stock Prices React to Dividend Changes
During recessions or otherwise uncertain times, dividend-paying stocks can rapidly decrease in value because there is a risk that future dividends will be reduced. If a company announces that it's lowering its dividend, the stock price will react immediately.
As the economy improves, the stock price might rise as investors hope that the company will once again increase its dividend. If the economy gets worse, the stock price might fall even further in anticipation that the company will completely stop paying the dividend.
Look Beyond Dividend Yields When Choosing Stocks
As stock prices fluctuate in anticipation of potential changes to dividend payouts, it's important to remember that the dividend yield doesn't account for those anticipations. Until the company officially announces a dividend cut, the dividend yield will continue to be calculated by the most recent dividend payouts.
The dividend yield only tells part of the story. Consider other factors like the stock's payout ratio, dividend history, and performance before making an investment decision.
Returning to the example from earlier, let's assume that a recession has hit, and the price of the stock dropped from $10 to $5. However, it's still weeks away from the time the company is expected to announce its dividend payment, so an investor who just found the stock uses previous dividend payments to calculate the yield. As the stock price plummeted, that $0.40 annual dividend jumped from a 4% yield to an 8% yield.
If an investor is only concerned with dividend yield, this would seem like a great opportunity. However, a wise investor would notice that the stock price had recently plummeted, and that's why the yield is so high. The wise investor would see that a dividend cut is likely on the way, so they wouldn't use the dividend yield as an indicator of whether to buy the stock or not.
You don't have to buy individual stocks if you don't know how to analyze them. Instead, you can invest in dividend income funds, which own a portfolio of dividend-paying stocks. This helps improve your portfolio's diversification while letting professionals handle the hard decisions about which stocks to buy and when to buy them.
Of course, the trade-off is that you'll compensate the fund managers who make these decisions for you. You can find out how much a fund charges by looking up its expense ratio.
These funds may use the term “distribution rate” rather than “dividend yield” to describe the amount of income they pay throughout the year. It's more common for mutual funds to use the term "distribution rate." High-yield ETFs, on the other hand, may simply use the term "dividend yield."
Dividend Yield vs. Bond Yield
Bond yields are calculated similarly to dividend yields, but it's important to remember that stocks and bonds are different products. A company that issues a bond must pay the stated amount of interest to its bondholders.
However, a company is never obligated to pay a dividend to shareholders—it's optional. This means that, during uncertain times, you can depend on investment income from bonds more than from dividend-paying stocks.
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.
SEC Office of Investor Education and Advocacy. "Dividend." Accessed April 13, 2020.
SEC Office of Investor Education and Advocacy. "Stocks." Accessed April 13, 2020.
Financial Industry Regulatory Authority. "Closed-End Fund Distributions: Where Is the Money Coming From?" Accessed April 13, 2020.
SEC Office of Investor Education and Advocacy. "Bonds." Accessed April 13, 2020.