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What is the Dividend Yield and how do you Calculate it?
A dividend yield is a measure of how much income you should expect to derive relative to the current price of the stock. Another way to look at it is dividend yield is a way of calculating your return on your investment (ROI). The formula for calculating the dividend yield is:
Before we go over an example of how to calculate dividend yield, you must know that not all companies pay dividends. Usually mid-cap companies with market capitalizations of $1B to $10B are in growth mode, so they do not pay dividends; instead re-invest their cash earnings back in to the business to grow. However, large cap companies that have already grown huge usually like to interest & retain their investors by buying back stock at premium prices or by issuing dividend payments.
You should watch out for companies that have reduced earnings quarter after quarter, even though their dividend payments are high. This signals the company must 'cut its dividend' which is trouble for the stock price because as soon as investors in the world hear about a company cutting its dividend, they sell the stock at high volumes, putting downward pressure on the stock price. As an example, with the recent BP oil spill in the Gulf Coast of America and with BP announcing it has set up an Escrow fund for $20 billion to pay for emerging lawsuits, the company announced it will be cutting its dividend in the 2nd quarter of 2010. Here's a news paragraph from CBC.ca about BP's dividend cut:
"Shares of BP fell Monday as the company's board met
in London to decide whether to suspend its dividend because of the oil
spill in the Gulf of Mexico. BP shares closed down $3.30 US, or 9.7 per
cent, at $30.67 US on the New York Stock Exchange. They have lost almost
half their value since the deepwater rig explosion April 20."
As you can see, a dividend cut really hurts the stock price because it signals the company does not have enough cash to pay its dividend, which could further mean declining sales/growth or emerging problems in operations (which is the case for BP).
How to Calculate the Dividend Yield?
Assume Coca Cola Corp. is currently trading for $50/share and the company pays a dividend of $0.25/share every quarter. If we look at it from an annual perspective, Coca Cola would be paying:
Now that we know the annual dividend per share, we can calculate the yield.
Thinking of buying the Coca Cola stock? You should look at other companies within its Consumer Goods industry to see if there are higher growth & better yielding companies.
Don't Buy Stocks Just based on their Dividend Yield
If the price of a dividend paying stock falls rapidly on the stock market, there might be an underlying reason why this is happening. Perhaps sales are hurting during the recession or the company has screwed up its operations and is facing lawsuits. If this is the case, the stock price will take this into account and will be hit downward by huge selling pressure from investors. This means the company may have to cut its dividend or scrap it altogether. The market will anticipate such moves by management early on and the stock price will reflect all of the information.
Video: What is the Dividend Yield?
A great video below from SavingandInvesting.com from Michael Fisher. He discusses the concept of dividend yields in great depth and it will help you learn a lot more about dividends. I like how he compares the dividend yield to a rental yield on a property. The rental yield is the amount of income the property generates in a year, expressed as a percentage to the total value of the property. For instance, if the property is worth $100,000 and total annual rental income from the property is $10,000, then the rental yield would be: