Stocks are pretty fickle by their very nature. It’s difficult to tell if one is going to increase or decrease at any given moment. With this uncertainty, most people take it upon themselves to measure the scale of a specific company’s stock. One way to do this is by using a form of measurement called a ‘dividend yield.’
If you’re unfamiliar with stocks, chances are you have never heard of this concept. This article will explain what exactly it is and why it is vital.
What is it?
A dividend yield is an incredibly important factor in determining the overall value of dividend stock. It’s especially useful for investors that seek to extract dividend income from their investments.
To elaborate, a ‘dividend’ is the distribution of a reward from a portion of a company’s earnings. It is paid to a group of its shareholders. Dividends are typically something that a company’s board of directors decide on and manage. However, the shareholders must approve them by way of their voting rights. They can be cash payments, shares of stock, or any other property type, but cash dividends are more common.
The dividend yield is the general scale of a company’s annual dividend in comparison to its share price. The concept is a simple way to measure the relative attractiveness of various stocks. Depending on exactly how much a stock price moves throughout the day, the yield is constantly transforming as the stock price changes.
Breaking it down
Most companies will pay a quarterly dividend that is pretty predictable to investors. These companies will commonly pay a regular quarterly dividend around the same time each and every year. A majority of these companies raise their dividends once a year. This leads to them being put on ‘10-year dividend increasers’ and ‘Dividend Aristocrat’ lists.
Now, for a company whose stock price is actively trending upward, it will definitely need to raise its dividend payout. Doing this will effectively maintain its dividend yield.
Here is an example that will further illustrate this. Let’s say a specific stock were to go up by 50%, but it fails to raise its dividend. That would mean its yield will consequently drop.
While high dividend yields are indeed appealing, they may come at the cost of growth potential. For every dollar that a company pays in dividends to its shareholders, it is a dollar that the company isn’t reinvesting. Moreover, it will not grow and they will not generate capital gains. This is a rise in the general value of a capital asset (a significant piece of property). This gives it a much higher worth than the purchase price. The gain is usually not acknowledged until the asset is officially sold. They will range from being short-term (one year or less) to long-term (more than one year).
Shareholders can garner high returns if the value of the stock were to increase while they’re holding onto it.
How to calculate it
In order to properly calculate dividend yield, use the following formula:
As you can see, calculating the yield is done by dividing the annual dividend by the current stock price. For example, let’s say that a stock has a share price of $50 and an annual dividend of $1. Its yield will equal out to 2%.
$1 / $50 = 0.02
If the share were to rise to $60, but the dividend payout did not increase, its yield would drop to 1.66%. You calculate the dividend yield by using the annual yield, which is based on every regular payout from that year. You do not use the quarterly, semi-annual, or monthly payouts to calculate the yield.
Watch out for the higher ones
As previously mentioned, high dividend yields are not all they crack up to be. An investor wanting to put together a portfolio that generates high dividend income should hold reservations on a company’s dividend payment history. Only corporations with a consistent record of gradually growing dividends during the past 20 years or longer. And this is if inclusion is taken into consideration.
Furthermore, the investor needs to be sure that the company can continue to produce the cash flow. This money distribution is a necessary part of making dividend payments.
Take the subprime mortgage crisis of 2007-09 for example. Companies were often showing yields that were in the 10%-20% range. However, that was only because the stock price was hit pretty hard, which is where the higher dividend yield comes from. This situation serves as a cautionary tale about being careful when you’re eager to jump into a stock because the yield may be high.
Reasons for a high level
When it comes to analyzing a high yield, it is very important to figure out why the yield is high. There are two reasons as to why a stock may have an incredibly high yield:
- The stock price took a big hit.
What leads to an increase in the dividend yield? It’s when a stock price declines and the dividend payout does not change. For instance, let’s say a stock was initially $50 with a $1 annual dividend. That would mean its dividend yield would be 2%. Now, let’s assume the stock’s share price fell to $20 and the $1 dividend payout stays the same. If that’s the case, its new yield would be 5%. While this 5% yield appears to be attractive, this is really a value trap.
It is crucial for investors to understand why a stock’s yield is remarkably high. A company whose stock price has fallen from $50 to $20 is most likely struggling. This is not what one would consider being a solid investment.
A notable example of this situation is the homebuilder stocks from 2008 to 2009. Specifically, the status of the stocks during the financial crisis around the time. The chart below shows a dividend yield for the company, Lennar, during this financial crisis. As you can see, it is experiencing inflation. The blue line illustrates the falling stock price and the black line shows its climbing dividend yield.
- Is it a REIT or is it an MLP?
REIT stands for ‘Real Estate Investment Trusts’ and MLP stands for ‘Master Limited Partnerships.’ These are very popular among most dividend investors. This is because they tend to offer much higher dividend yields than stocks. These companies usually offer high dividends since they need to distribute roughly 90% of earnings to shareholders. The distribution of these earnings is typically in the form of dividends. These particular companies do not pay regular income tax on a corporate level. In lieu of this, the taxes are handed over the investor.
If it hasn’t become apparent already, it is wise for investors to keep dividend-friendly industries in mind. Here are some of the best industries regarding dividends:
- REITs – Corporations that are under federal obligation to invest only in real estate.
- MLPs – Partnerships under limitations that trade on securities markets, much like normal stocks.
- Tobacco – Companies that produce and distribute a variety of paper products to customers and businesses of all sorts.
- Telecommunications – Companies that provide communication services for voice, data, and video transmissions by way of a variety of methods.
- Utilities – Companies that offer electric, water, and gas utilities for both individuals and businesses.
Along with REITs and MLPs, business development companies (BDCs) also have high-level dividend yields. Much like MLPs, the companies have a structure that leads to the U.S. Treasury requiring them to pass most of their income to shareholders. The pass-through procedure means that – as mentioned before – the company doesn’t have to pay income taxes. The shareholder, however, has to treat the payments as “ordinary” income on their taxes. These dividends are not adequate for capital gains tax treatment.
The higher tax liability on regular dividends lowers the ‘effective yield’ that the investor has. This is the yield of a bond that reinvests its coupons after the bondholder receives the payment. However, after adjusting for taxes, REITs, MLPs, and BDCs still pay dividends with an incredibly high yield.
As expected, there are drawbacks surrounding dividend yields. Evaluating a stock by drawing from its dividend yield alone is a mistake. Dividend data can be very old or basing their information off inaccurate information. Majority of companies possess a very high yield as their stock is falling. This will usually happen before the dividend is cut.
The average dividend yield can easily be calculated from the last full year’s financial report. Admittedly, this is perfectly acceptable; at least during the first few months. This is after the company releases its annual report. There is a catch to this, though. The longer it has been since the annual report, the less relevant the data becomes for investors.
Alternatively, investors equal out the last four quarters of dividends. This will capture the ‘trailing 12 months’ (TTM) of dividend data. Utilizing a trailing dividend number on its own is fine, but it could potentially make the yield too high or too low. This is especially true if the dividend has recently been cut or it has gone through a raise.
Paying a dividend is a quarterly protocol, so many investors will take the last quarterly dividend and multiply it by four. Then they use the outcome as the annual dividend for the yield calculation. This approach will demonstrate alterations in the dividend. However, not all companies pay an even quarterly dividend. There are some firms that pay a small quarterly dividend with a large annual dividend. If the performance of the dividend calculation takes place after the large dividend distribution, it will give an inflated yield.
There is a lot that can be said about dividend yields. Likewise, there is a lot that can be said about dividends themselves. Hopefully, this article properly served its purpose as a guide to better explaining what they are.