Dividend yield

DIVIDEND YIELD RATIO DEFINITION

Common stock investments have 2 sources of return i.e. dividend and capital appreciation. The percentage return received from dividends is known as dividend yield and return from capital appreciation is known as capital gain yield.

Dividend yield ratio is a financial ratio used to measure the percentage return received from the dividend relative to its market price. In simple language, it states that how many dollars you are receiving as dividends for every 100 dollars invested in the stock.  It is a useful measure for investors, who are more interested in dividends as a source of regular income.

DIVIDEND YIELD FORMULA

It can be calculated by the following two formulas.

Formula 1:

Dividend Yield = Annual Dividend Per Share
Stock Price per Share

As mentioned in the first equation, you can calculate the ratio by dividing the annual cash dividend payments by market capitalization of the company.

  1. Annual Dividend Payments: Only cash dividend payments are included in this. Cash dividend payments can be found on the financial statements easily.
  2. Market Capitalization: Market capitalization can be found by multiplying the market price of the share with the number of common shares outstanding. Market prices are available on the website of exchanges and number of common shares outstanding can be found from financial statements.

Formula 2:

Dividend Yield = Annual Dividend Per Share = Earnings per Share (EPS) * Dividend Payout Ratio (DPR)
Stock Price per Share

The second equation is simpler as it computes the ratio by including per share data of dividend and market price. Both of these data are more easily available compared to the first equation.

Please note that it is always expressed in percentage terms and just like dividend payout ratio, both numerator and denominator includes the data related to common shares only. Preference share and preference dividends are not included.

DIVIDEND YIELD CALCULATION WITH EXAMPLE

Let us understand the ratio with an example of two companies:

Description Company X Company Y
Earnings per share (EPS) …. (A) 5 $/Share 25 $/Share
Dividend per share (DPS) …. (B) 2 $/ Share 12 $/ Share
Market Price of Share (MPS) ….(C) 25 $/ share 200 $/share
CALCULATION OF DIVIDEND YIELD AND DPR
Dividend Payout ratio= (B/A)* 100 = DPS / EPS

= $2/$5

= 40%

= DPS / EPS

= $12/$25

= 48%

Dividend Yield= (B/C)*100 =DPS/MPS

= $2/$25

= 8%

=DPS/MPS

= $12/$200

= 6%

 

Here, the dividend yield is calculated using formula 2 which is explained in the table above.

DIVIDEND YIELD ANALYSIS AND INTERPRETATION

A dividend yield of 8% suggests that the investor will get a return of 8% (apart from capital gain) if he buys the stock at current market prices. In the example above, company X is considered better as it is having 8% dividend yield compared to 6% of company Y.

It should also be noted that the dividend decisions of a company also depends on the industry of the company. For an apple to apple comparison, the comparison should be done between companies of the same industry.

DIVIDEND YIELD VS DIVIDEND PAYOUT RATIO

Dividend payout ratio will only show how much part of earnings is distributed as the dividend to shareholders. Whereas, dividend yield shows how much % return an investor would earn if he invests in a stock at current market prices. So, if the objective is to assess a company on ‘better dividend returns’, then dividend yield will be the right choice.

In the example shown above, it is clear that company X wins the race with 8% return compared to 6% return of company Y.

Dividend Yield

DISADVANTAGES OF USING DIVIDEND YIELD AS A METRIC

  1. Misleading in Stock Market Fluctuations: Due to temporary market ups and downs also, the market price of the share may increase or decrease. When prices decrease, the dividend yield ratio would increase and vice versa. So, you will have to make an adjustment for such fluctuations by taking the average of last 3 years prices so that it does not lead to faulty interpretation.
  2. Insufficient as an Overall Return Metric: Also, dividend yield should not be the sole criteria to form an opinion on a company. There are some profitable companies in the market that do not pay dividends as they have profitable investment opportunities so they choose to reinvest their earnings. These stocks provide low dividend yield but they provide a better return through capital appreciation.
  3. Dividend – a Compulsion: There are some mature companies which pay a higher amount of their earnings as dividends because they don’t have profitable reinvestment opportunities. These stocks provide high dividend yield but not necessarily a better return through capital appreciation. So only higher dividend yield does not mean that the company is doing well. You need to use other metrics and criteria for your analysis along with this.

Dividend Yield Fund

As we know, a person invests in Mutual Funds to earn returns. The Mutual Funds distribute dividends to the shareholders if they have surplus funds. However, when it comes to Dividend Yield Funds, people expect that they will be paid regular dividends even if there is surplus or not. This is not true.

Dividend Yield Fund is a fund in which there is no obligation to pay dividends to the investors. This fund invests money in those companies that have the ability to pay regular dividends. In this fund, the major part of the portfolio comprises of companies that have high dividend yield ratio. The ratio of investment can be 80:20 in favor of high yielding dividend stocks.

The selection of stocks in Dividend Yield Fund is done after studying the fundamentals of the company. To find our good stocks, basic benchmark evaluations like EPS, PE Ratio, etc. are considered. Other major aspects that are considered before selecting the stocks are; stability and consistency in paying dividends, future growth, management and fundamentals of the company.

CONCLUSION:

So, the investor looking for some regular income through investment should consider dividend yield as a metric for comparison. The usage of this metric is limited to dividends only as we just discussed the flaws of this metric. Hence, for an overall return perspective, it is advisable to look at the larger picture by considering the industry in which company operates, past dividend patterns, dividend policy and investment opportunities available to company etc.

 References:

  • Financial Management by Ravi M. Kishore
Last updated on : January 13th, 2018
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Interim Dividend
  • Dividend per share
    Dividend per share (DPS)
  • Stock Split
    Stock Split
  • Special Dividend
    Special Dividend
  • Dividend Payout Ratio
    Dividend Payout Ratio
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