A stock's dividend yield tells you how much dividend income you receive, compared to the current price of the stock. Buying stocks with a high dividend yield can provide a good source of income, but there are other factors to take into account.
When investing in dividend-paying stocks, you'll want to learn what the dividend yield is, how it relates to the share price, and what pitfalls to avoid.
How to Find the Dividend Yield of a Stock
The formula for finding a dividend yield is simple: Divide the yearly dividend payments by the stock price.
Here's an example: Suppose you buy stock for $10 a share. The stock pays a dividend of 10 cents per quarter, which means for every share you own, you will receive 40 cents per year. Using the formula above, divide $0.40 by $10, giving you 0.04. Next, convert 0.04 into a percentage by moving the decimal two places to the right. The result is 4%, meaning this stock has a 4% dividend yield.
Which Companies Issue Dividends?
A dividend is how a firm returns profits directly to its shareholders. Companies aren't required to issue dividends, so there isn't a set rule about which will and which ones won't. Even if a company has issued dividends in the past, it may stop at any time.
Older, blue-chip firms with steady profit growth are more likely to issue dividends. But start-ups that are rapidly expanding are less likely to do so. That's because new companies need all the money they can get to fund their growth. This is true of start-ups, as they haven't yet managed to turn a profit. When you buy stock in these kinds of companies, you're hoping for an increase in stock price rather than steady income from dividends.
Stock Prices React to Dividend Changes
During a recession or other times of hardship, dividend-paying stocks can quickly decrease in value, because there is a risk that the firm will reduce payouts in the future. If a company says that it's cutting its dividend, the stock price will react right away.
As the market improves, the stock price might rise again, as investors hope that the company will increase its dividend once more. But if the economy gets worse, the stock price might fall even further. That's because investors worry the company will stop paying the dividend.
Look Beyond Dividend Yields
Unless a dividend cut is announced, the yield is still calculated using the most recent payouts.
The dividend yield only tells part of the story. Before making a decision, look at other factors, too. Some details to seek out include the stock's payout ratio, dividend history, and performance.
Recall the example from earlier, where the stock has a price of $10. Let's say that a recession hits, and the price of the stock drops from $10 to $5. But the company has not announced a change to the dividend payment. So, if you just found the stock, you would use previous dividend payments to figure out the yield. You would divide $0.40 (the yearly dividend payment) by $5 (the new stock price) to get 0.08, or an 8% yield.
If you only look at the dividend yield, this would seem like a great stock to buy. But it would be wise to notice that the stock price had fallen, and that's why the yield is so high. You might also guess that a dividend cut is likely on the way. In that case, you wouldn't use the dividend yield as your only reason to buy the stock.
If you don't want to study and purchase individual stocks, you can invest in a dividend income fund instead. These funds allow you to diversify your portfolio while letting experts make the hard choices about which stocks to buy and when to buy them.
There is a trade-off, though. You'll have to pay the fund managers who make these choices for you. To find out how much a fund charges, look up its expense ratio, which will tell you how much of the fund's assets are taken out to cover costs each year.
These funds may use the term “distribution rate” in place of “dividend yield.” High-yield ETFs, on the other hand, are more likely to use the term "dividend yield."
Dividend Yield vs. Bond Yield
Bond yields are calculated in much the same way as dividend yields. But it's still key to keep in mind that stocks and bonds are not the same.
A company must pay the stated amount of interest to those who own bonds it issues. On the other hand, a company is not required to pay a dividend to the people who own its stock. This means that, during uncertain times, you can depend on consistent investment income from bonds more than from dividend-paying stocks.
The Balance does not provide tax or investment advice or financial services. 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.