Dividend Yield – The 10 Things You Need to Know

Dividend yield is a key metric used by income-seeking investors to select securities for their investment portfolios.

While the dividend yield is relatively easy to calculate, there are additional considerations that investors need to know to analyze a particular security’s dividend performance properly. The dividend yield should not be used as the sole determinant of an equity’s worthiness and expected return but used with other financial indicators and metrics.

To understand the complex process of selecting the best dividend-paying equities, here are 10 basic things that every investor needs to know about the dividend yield.

1. What is a dividend yield?

A dividend yield is a financial measure that shows how much a company pays in total annual dividends compared to the company’s current share price. The dividend yield is usually expressed as a percentage of the share price. 

2. How do you calculate the dividend yield?

Dividend yield is calculated by dividing the total annual dividend amount by the company’s share price.

The result of the formula above yields a decimal number. Multiplying the entire expression by 100, results in a percentage.
For example, Verizon Communications Inc. (NYSE:VZ) paid a total annual dividend of $2.3225 per share for 2017. The share price closed at $48.64 on October 25, 2017. Therefore, the yield for Verizon is:

3. Are all dividend distributions included in the dividend yield calculation?

No. Only regular dividend distributions over a one-year period are used to calculate the yield. Special or extra dividends do not factor into the dividend yield calculation, as these are not recurring and are not scheduled to be paid in the next year.

4. What is the difference between a trailing dividend yield and a forward dividend yield.

To calculate a trailing dividend yield, use the actual total dividend paid over the previous 12 months. The calculation in the Verizon example above is an example of a trailing dividend yield.

For the forward dividend yield, the dividend distribution amount from the most recent period can be used to extrapolate an annualized dividend payout, which then is used in the yield calculation.

Verizon’s quarterly payments that comprise the $2.3225 total dividend amount for 2017 were as follows:

The company paid a same amount for the first three quarters of the year and then hiked its quarterly dividend in the fourth quarter. Using the most recent period’s dividend amount, calculate the total annualized dividend as:

Annualized dividend = Most recent period’s dividend x Number of periods per year

While most companies distribute their dividends quarterly, there is no rule regarding dividend distribution frequencies. Some securities distribute their dividends monthly or semi-annually. In these instances, we calculate the total annualized dividend by multiplying the most recent period’s dividend amount by 12 and 2, respectively.

In the Verizon example, the annualized dividend payout amount would be:

Annualized dividend = $0.59 x 4 = $2.36

Because of the quarterly dividend hike in the fourth quarter, the annualized dividend of $2.36 is higher than the total actual dividend of $2.3225 paid in 2017.

Subsequently, use $2.36 – the annualized dividend payout – in the yield formula to calculate the forward dividend yield.

The forward yield of 4.85% is 1.6% higher than the 4.77% trailing dividend yield.

5. What does dividend yield measure?

Dividend yield measures the amount of cash flow that the investor receives for each dollar invested in that particular security. Therefore, a higher yield indicates that the investor will receive a higher annual cash income per dollar invested compared to a security with a lower yield. If a security has no asset appreciation, the dividend yield is de facto the total return on investment.

6. Should investors pick securities with the highest dividend yields for investing?

Not necessarily. While higher dividend yields mean higher cash income, yields that are too high could indicate that the company is distributing too much of its earnings and might not retain enough cash to support daily operations or strategic expansion. Since the dividend yield is not an absolute value but a ratio, a low share price could be the reason for high yields. Additionally, equities with very high dividend yields could have very high payout ratios – above 100% – which are not sustainable over long periods.

7. What is a good dividend yield level?

The definition of a good dividend yield depends on multiple factors, such as the investor’s portfolio strategy, the investor’s personal preference, various market factors, the equity’s industry sector, longevity of the dividend distribution, etc. Investors who seek exceptional cash income will look for securities with very high yields. However, investors looking for a balanced strategy of dividend income and asset appreciation might be willing to trade the very high dividend yield for a few additional points on the asset appreciation side.

According to research conducted by the New York University’s Stern School of Business, the average dividend yield of all the companies in the U.S. market was approximately 2%, as of January 2017. Some companies with well-established dividend records and long-term share price growth are good buys with yields above the 2% mark. For instance, the 51 companies currently designated as Dividend Aristocrats because of their 25-plus-year record of consecutive dividend hikes, had a 2.4% average yield as of August 2017. However, for most other companies, investors should look for at least 3%. With very few exceptions, the upper limit of the yield should be 20%, if the share price is not falling and if the payout ratio is below 50%.

8. Is a rising dividend yield a good indicator that the security is a buy?

Not necessarily. A rising dividend amount is usually a good indicator. However, a rising dividend yield can be just a result of a fast-falling share price. In most cases, the return generated by the rising dividend income is rarely sufficient to offset the declining asset value.

9. What is total return?

The total return is the sum of combined returns generated by dividend income and asset appreciation. For instance, a security with a 6% share price growth and a 3% trailing dividend yield over the same 12-month period has a 9% total return. Analogously, another security that pays a 4.5% trailing dividend and has a 4.5% one-year share price growth has a total return of 9% as well.

10. What does the dividend yield level imply about the company?

The dividend yield level can indicate a company’s share price value relative to its peers. High dividend yields can indicate that a company currently is distributing a larger-than-normal share of its earnings as dividend distributions to attract investors or that the company might be undervalued. Correspondingly, low dividend yields can indicate that a company currently is overvalued or that the company is focusing on capital growth at the expense of dividend income distribution.

However, for established companies in high-yield sectors, high dividend yields do not have to mean that the company is overvalued. Also, new companies that are focused on expansion and growth generally will have very low dividend yields – if they pay dividends at all – which does not have to be an indication that the company is overvalued.

The dividend yield is an important indicator for evaluating financial strength of securities. However, investors must use the dividend yield in conjunction with other indicators to gauge whether an equity looks like a good investment choice overall and whether the equity fits with the investor’s portfolio strategy.

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