Understanding the Dividend Yield on a Stock

Dividends can be cut and yields can change rapidly

Dividend Yield on a Stock
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A dividend yield tells you how much dividend income you receive in relation to the 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.

Companies don't have to pay dividends. Trouble comes when a company lowers its dividend. The market will often anticipate this move, and the stock price will drop before the company announces its plans to lower the dividend.

Since the share price has dropped, when you look at the dividend yield based on the last dividend the company paid, it will seem high. If you buy the stock based on that high dividend yield, you could be in for a big surprise if the company lowers or eliminates the dividend.

To be successful at investing in dividend-paying stocks, understand the relationship between the share price and the dividend yield. The first step is knowing how to calculate a dividend yield.

Calculating the Dividend Yield on a Stock

The formula for calculating a dividend yield is relatively simple:

  • Let’s say you buy a 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.
  • This stock has a 4% dividend yield ($0.40 divided by $10 multiplied by 100).

Companies don't have to pay dividends. During recessions, companies may lower the dividend they pay on their stocks or stop paying a dividend altogether. In that case, the dividend yield could rapidly go to zero.

Why Don't All Companies Pay a Dividend Yield?

Whether true or not, you'll hear investors say that new and growing companies don't pay a dividend yield while older, more mature and stable companies will. When Apple began paying a dividend, many saw that as its transition from a rapidly growing tech company to one where the rapid growth was over.

Smaller, newer, rapidly expanding companies need all the money they can get to fund their expansion. For this reason, they don't usually pay a dividend yield. Investors are more than happy to capitalize on the rising stock price. For companies that no longer see rapid price appreciation, companies pay the dividend yield to entice investors to hold their stock.

Stock Prices React Quickly to Changes in Dividend Payouts

In uncertain times, dividend-paying stocks, or dividend-paying stock funds, 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 in anticipation 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.

Don’t Buy Dividend Stocks Based Solely on Yield

If the price of a dividend-paying stock rapidly drops, there is a reason. It means there is a very real chance the company may reduce or stop paying the dividend in the near future. The market will often anticipate these changes, and that anticipation is reflected in the stock price.

For example, you see a stock that has a dividend yield of 10%. The stock price is $10 a share. Last year the stock paid a dividend of $0.25 per quarter, or $1 a year. You are excited to find a stock that pays such a high level of income. You buy the stock. A few days later, the company announces that it is going to cut its dividend to $0.10 per quarter ($0.40 per year). The stock price rapidly drops to $5 a share.

Look Beyond the Dividend Yield

The dividend yield only tells part of the story. Consider other factors like the stock's payout ratio, dividend history, and performance when compared to similar companies before making an investment decision.

Before Buying Individual Stocks, Look at Dividend Income Funds

Dividend income funds own a portfolio of dividend-paying stocks. These funds use the term “distribution rate” rather than “dividend yield” to describe the amount of income they pay out.

If you don't know how to analyze individual stocks, then don't buy them. Use a dividend income fund instead. They have analysts who do the work for you, and although you pay an expense ratio inside the fund, it may save you from making a bad investment.

How Does a Dividend Yield Compare to a Bond Yield?

Bond yields are calculated similarly to dividend yields. However, a company must pay the stated amount of interest to its bondholders, but paying a dividend to stockholders is optional. This means that during uncertain times, your future investment income is more secure if you own an interest-paying bond instead of a dividend-paying stock.

Diversify Your Holdings

Investors like to hold different types of investment products to help protect against sudden drops in a particular area of the investment market. This is called diversification. One way to diversify is to hold a combination of dividend-paying and non-dividend-paying stocks. In other words, consider owning a mix of growth stocks and income stocks. Because dividend-paying stocks often don't react as severely to overall market moves, income stocks represent stability in tough times while growth stocks will return impressive gains during strong market conditions.