Dividend Yield

Dividend Yield Ratio: Definition

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

The 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 how many dollars you are receiving 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

Dividend yield calculation can be done using 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 the 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 the number of common shares outstanding can be found in 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 readily available compared to the first equation.

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

Dividend Yield Calculation with Example

Let us understand the ratio with an example of two companies to understand dividend yield calculation:

DescriptionCompany XCompany Y
Earnings per share (EPS) …. (A)5 $/Share25 $/Share
Dividend per share (DPS) …. (B)2 $/ Share12 $/ Share
Market Price of Share (MPS) ….(C)25 $/ share200 $/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, we calculate the dividend yield using formula two as per 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 has an 8% dividend yield compared to 6% of company Y.

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

Dividend Yield vs. Dividend Payout Ratio

It is very important for one to understand the difference between dividend yield and payout ratio. The dividend payout ratio will only show how much part of the earnings company distributes as the dividend to shareholders. Whereas dividend yield shows how much % return an investor would earn if he invests in 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 an 8% return compared to the 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 the 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 a low dividend yield, but they give a better return on capital appreciation.
  3. Dividend – a Compulsion: There are some mature companies that pay a higher amount of their earnings as dividends because they don’t have profitable reinvestment opportunities. These stocks provide a high dividend yield but not necessarily a better return through capital appreciation. So only a 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 get regular dividends even if there is a surplus or not. This is not true.

A 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 companies with a high dividend yield ratio. The ratio of investment can be 80:20 in favor of high-yielding dividend stocks.

The selection of stocks in a dividend yield fund is made after studying the fundamentals of the company. To find our good stocks, we consider basic benchmark evaluations like EPS, PE Ratio, etc. Other major aspects under consideration 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 the company operates, past dividend patterns, dividend policy, investment opportunities available to the company, etc.



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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