Understanding the Dividend Yield Definition

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As an investor in the stock market, I am sure you have heard the term dividend yield at some point.

It is one of the most referred to ratios for a dividend income investor.

While I don’t believe it is the best metric to use when picking a dividend stock, it certainly holds some value.

Before we get started, I would caution any new investor from picking a stock just with a high yield. This is commonly referred to as “chasing the yield” … and it can eventually hurt your portfolio.

I personally focus more on future growth when building my dividend stock portfolio. But that doesn’t mean the yield is not important to understand.

Let’s take a closer look at the dividend yield definition. That way you will understand it a little better when it comes time to build your income portfolio.

Dividend Yield Definition

So what actually is the definition of dividend yield?

According to Investopedia – β€œThe dividend yield, expressed as a percentage, is a financial ratio (dividend/price) that shows how much a company pays out in dividends each year relative to its stock price.”

For more information – check out the dividend yield.

Often referred to as the current yield, this financial ratio is a way to measure the cash flow an investor will get for each dollar they invest in a given security (or company).

So if the current yield of a company is 5% … then for every dollar you invest … you’d receive 5% back. That would be $.05 each year in the form of a dividend payment back into your brokerage account.

For this reason, I like to think of the dividend yield calculation as the annual cash return on investment (ROI). So in our example above, if I invest $1,000 … my return on investment in dividends will be $50 for the year.

The ROI discussed above only represents the dividend payments received and does not consider any capital gains or losses.

By the way … finding a sustainable 5% dividend yield is a lot harder than it sounds.

How Can I Find the Yield for a Company

The dividend yield for a company can be found on any investment website that provides financial data for companies. I usually go to Yahoo! Finance when looking up the dividend yield for a stock.

Investors can also find this information on a company’s website or can even calculate the ratio themselves.

Personally, I think it is a great idea to get your hands dirty and calculate the dividend yield yourself.

In order to better understand the numbers, you need to know where they are coming from.

Dividend Yield Formula

Calculating the dividend yield for a stock is rather simple.

The dividend yield of a stock can be calculated by dividing the annual dividends paid out by the current share price.

This can be done using the dividend yield formula

Dividend Yield = Annual Dividends / Current Share Price

Let’s look at an example.

Company ABC (which is made up) is currently trading at $20 per share. Over the past 12 months, the company has paid out $1.00 in dividends for every 1 share of stock.

At the current share price … the company has a 5% dividend yield.

The calculation would look something like this –

ABC’s Current Yield = $1.00 Annual Dividends / $20 current share price

In this scenario … if the dividend were sustainable, I think it would be a great stock to own. But as I said before … finding a quality company that can maintain a 5% yield is difficult.

So how should an investor use the dividend yield when looking for stocks?

How to Use the Dividend Yield

While the dividend yield gives investors a lot of useful information, it does not tell the whole story. There are several factors to consider when using the dividend yield of a stock.

In our previous equation, we calculated an investor purchasing shares of ABC (made up company) would get a 5% yield.

But in order to get that 5% yield … the investor would have to purchase the shares at $20 exactly.

The thing is … yields for a stock are always changing as long as the share price is rising or falling.

At a $20 share price and $1 in annual dividends … the yield is 5%. But what happens when the share price goes up for a stock? Or when the share price goes down for a stock?

Share Price Increases = Lower Yield

At first this might sound wrong … but when the share price of a stock goes up … the yield goes down.

For example, if the share price of ABC rises to $25 … the yield would drop to 4%.

Assuming the $1 in annual dividends remains unchanged, the new dividend yield would look like this –

ABC’s Current Yield = $1.00 Annual Dividends / $25 current share price

New Dividend Yield = 4.0%

Share Price Decreases = Higher Yield

Now let’s look at what happens when the share price drops … yep the yield goes up this time.

If the share price of ABC suddenly drops to $15 (instead of $20) … the yield would rise to 6.7%.

Assuming the $1 in annual dividends remains unchanged, the new dividend yield would look like this –

ABC’s Current Yield = $1.00 Annual Dividends / $15 current share price

New Dividend Yield = 6.7%

Annual Dividend Changes can Change the Yield

Yet another reason the yield can rise or fall is the other part of the dividend yield formula – annual dividends.

Most yield calculations use dividends paid to shareholders during the past 12 months. This is normally called the trailing 12 month dividend.

As we all know, the past is not necessarily any indication of the future. A stock with a sporadic dividend past could suddenly cut their distribution sending the current yield spiraling down.

In our example, if the share price of ABC remains at $20 but the company cuts their dividend to $0.50 per share … the yield drops.

ABC’s Current Yield = $0.50 Annual Dividends / $20 current share price

New Dividend Yield = 2.5%

As a dividend investor myself, I don’t want to be caught with a stock that decides to make one of these cuts.

Solid growth companies on the other hand are known to raise their dividends every year.

Sticking with the same example, the share price of ABC remains at $20. But they recently announced a 6% dividend increase for the year. That increase translates to an annual dividend of $1.06 (instead of $1).

Now the current yield has risen by a bit this time around.

ABC’s Current Yield = $1.06 Annual Dividends / $20 current share price

New Dividend Yield = 5.3%

Yield on Cost per Share

Using the dividend yield of a stock can be very helpful to identify potential investments. However, once an investor purchases shares of the stock, the current yield becomes irrelevant to the investor.

Since the investor paid a specific price for the stock, it will no longer represent the current share price and will not give a true picture of their return on investment in the future.

An alternative ratio that can help in this case is known as the yield on cost.

The yield on cost calculation is a bit out of scope for this article … but it takes out one of the variables in the equation – current share price.

Personally I prefer to track my yield on cost for stocks in my income portfolio once I purchase my shares. It represents the cash return for the price I paid to buy my specific shares.

Investing in Dividend Stocks

The dividend yield definition should be simple to understand for most investors.

It is also referred to as the “current yield”.

This simple financial ratio represents a company’s potential cash return on investment. It can be used to help investors select quality income stocks.

Investors who use this calculation however should recognize the potential flaws in the numbers and factor it into their investment decisions.

When the share price of a stock falls … the yield goes up. This could be tempting but may also be a trap.

On the other hand … when the share price increases … the yield goes down. For that reason, many great dividend paying companies get ignored because of a low yield.

Personally, I prefer to focus more on dividend growth stocks instead of companies with a high yield.

Do you understand the dividend yield definition and how to use it in your stock selection criteria? If so, what percentage yield do you look for?

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