Dividend yield is a ratio that compares the amount of dividends paid out per year to the price of a company's stock. Assuming no change in the price of the stock during the measurement period, the ratio approximates the return on investment for the shareholder. The calculation is the amount of dividends paid per share per year, divided by the price per share. The formula is:
Dividends paid per year ÷ Market price of stock
The dividends paid figure is easy to determine and may be relatively stable, but the stock price used in the denominator of the equation can be a problem, since it may fluctuate significantly over even a short period of time; you may need to use a monthly average stock price for this figure.
The dividend yield concept is used by investors to determine which shares will pay them a higher return on investment if they were to purchase the shares. An investor should not solely base a purchase decision on the dividend yield, since a company in financial trouble might still have a high dividend yield. Instead, you should also evaluate the payout ratio, which is the proportion of earnings being paid out to shareholders as dividends. If the payout ratio is high, and especially if it is increasing over time, this means that the company may not be able to support the current dividend level for much longer, and also may be experiencing significant financial difficulties that could result in a rapid decline in the price of the stock.
If a company has multiple classes of stock on which dividends are paid, each class of stock may have a different dividend yield. This situation arises when a company has preferred stock on which it pays dividends, and common stock on which it pays separate dividends.
If a company is in a slow-growth industry and cannot find other uses for its cash flow, it is more likely to pay out a higher dividend yield to its investors, thereby attracting investors who are more interested in steady income from the dividends. If a company is in a high-growth industry and is using all available cash flow to fund its operations, there may be no dividend yield at all, which attracts a different group of investors who are more interested in achieving capital gains from having the price of the stock increase over time.
Example of Dividend Yield
An investor has a choice between investing in the stock of Company A and Company B. Company A has been paying $2.00 in dividends on its stock for the past few years, while Company B has been paying only $1.50. However, the share price for Company A stock is $40, while the share price for Company B stock is $25. Thus, the dividend yield for Company A stock is 5% and it is 6% for Company B stock. If the dividend yield is the only consideration, then the investor should purchase the stock of Company B.