Dividend Yield

The dividend yield, expressed as a percentage, is a financial ratio that presents the amount a company pays in dividends each year relative to its stock price. The reciprocal of the dividend yield is the dividend payout ratio. This article discusses what does dividend yield mean and what is dividend yield in the share market.

What is dividend yield?

Dividend yield means that it is estimate of dividend-only return of stock investment. dividend yield will rise when price of stock falls. Conversely, it will fall when stock price rises. Mathematically, dividend yields change relative to stock price, & they can often look unusually high for stocks falling in value quickly.

What is dividend yield in stocks: Understanding dividend yield

Dividend yield is ratio which express how much income one earn in dividend payouts each year for every dollar invested in stock, mutual fund or exchange-traded fund (ETF).

Fast-growing, relatively small businesses may have lower average dividend payments than more established businesses in same industries. Generally speaking, dividend yields are highest for established businesses that expand slowly. whole sectors that pay greatest average yield are consumer non-cyclical firms that sell utilities or staple goods. technology sector is subject to same regulation that applies to mature corporations, notwithstanding fact that dividend yield among technology stocks is lower than average.
 

Calculating the Dividend Yield

The formula for dividend yield is as follows:

Dividend Yield = Price Per Share/Annual Dividends Per Share

One can calculate the dividend yield based on the previous year's financial report. These reports are acceptable during the first few months after the company has released its annual report. However, the longer it has been since the annual report, the less relevant that data is for investors. Alternatively, investors can add the last four quarters of dividends, which captures the trailing 12 months of dividend data. A trailing dividend number is acceptable, but it can make the yield too high or low if the dividend has recently been cut or raised.

As dividends are paid quarterly, many investors will take the last quarterly dividend, multiply it by four, and use the product as the annual dividend for the yield calculation. This approach will reflect any recent changes in the dividend, but not all companies pay an even quarterly dividend. 

Some companies also pay a dividend more frequently than quarterly. A monthly dividend could result in a lower dividend yield calculation. When calculating the dividend yield, an investor should look at the history of dividend payments to decide which method will give the most accurate results.
 

Example of Dividend Yield 

Suppose company A’s stock is trading at INR 20 and pays its shareholders annual dividends of INR 1 per share. Suppose Company B's stock is trading at INR 40 and pays an annual dividend of INR 1 per share. 

This means Company A's dividend yield is 5% (INR 1 / INR 20), while Company B's dividend yield is only 2.5% (INR 1 / INR 40). Assuming all other factors are equivalent, an investor looking to use their portfolio to supplement their income would likely prefer Company A over Company B considering the double dividend yield.
 

Dividend Payout Ratio

The following formulas can be used to calculate DPR:
1. Dividends paid out total (DPR) / net income

2. DPR = 1-Retention Ratio (the inverse of the dividend payout ratio, the retention ratio indicates the portion of net income held by the business as retained earnings).

3. Dividends per share less earnings per share equals DPR.

A Dividend Pay-out Ratio Example:

For the year, Company A declared a net income of 20,000. Company A declared and distributed 5,000 in dividends to its stockholders during the same time period. This is how the DPR is calculated:
₹5,000 / ₹20,000 = 25% is the DPR.

Consequently, a 25% dividend payout ratio indicates that Company A distributes to shareholders 25% of its net income. Retained earnings are the remaining 75% of net income that the business retains for expansion.
 

Advantages of dividend yield

A prominent advantage of dividend yield is compounding. Historical evidence suggests that focusing on dividends may amplify returns rather than slow them down. For example, suppose an investor buys INR 10,000 worth of a stock with a dividend yield of 4% at an INR 100 share price. This investor owns 100 shares that all pay a dividend of INR 4 per share (100 x INR4 = INR 400 total). 

Let’s assume that the investor uses the INR 400 in dividends to purchase four more shares. The price would be adjusted on the ex-dividend date by INR 4 per share to INR 96 per share. Reinvesting would purchase 4.16 shares; dividend reinvestment programs allow for fractional share purchases. If nothing else changes, the next year, the investor will have 104.16 shares worth INR 10,416. 

The investor can reinvest more shares once the company declares a dividend, thus compounding gains similar to a savings account.
 

Disadvantages of Dividend Yields

1.    Lack of investments

While high dividend yields are attractive, they may be at the expense of the potential growth of the company. Every rupee a company is paying in dividends to its shareholders is a   that the company is not reinvesting to grow and generate more capital gains. Even without earning any dividends, shareholders can earn higher returns if the value of their stock increases while they hold it as a result of company growth.

2.    Erroneous information 

Investors should not evaluate a stock based on its dividend yield alone. Dividend data can be old or based on erroneous information. Many companies have a high yield as their stock falls. If a company's stock experiences enough of a decline, it may reduce the dividend amount or eliminate it.

3.    Denominator effect

Investors should exercise caution when evaluating a company that looks distressed and has a higher-than-average dividend yield. As the stock's price is the denominator of the dividend yield equation, a strong downtrend can dramatically increase the calculation's quotient.

What Affects Dividend Yield?

Dividend yield is influenced by a wide range of factors, including corporate performance, individual stock and fund prices, and general market circumstances.

1. Stock Prices: The company's stock price has the largest influence on dividend yield. Dividend yields decrease when share prices rise, unless businesses decide to increase dividend payments.

A falling dividend yield brought on by an increase in stock price isn't always a bad thing. It can indicate that investors believe the company is a superior investment and are more confident in it. Additionally, the appreciation that a rising stock price provides can counteract a declining dividend yield.

2. Industry Trends: Because dividend yields can differ significantly throughout sectors, industries, and fund categories, it's critical to compare the yields provided by businesses in the same industry, or funds in the same category, when assessing dividend yields.

In certain industries, such as consumer discretionary companies, average dividend yields experienced significant drops. Discretionary goods companies saw a decline in earnings and dividend payments as a result of Americans being confined to their homes and limited to purchasing necessities.

The average dividend yield for other industries was greater, such as energy stocks. Energy prices rose as a result of global economic disruptions, which also raised oil and gas businesses' earnings. These corporations then passed the gains on to their investors in the form of greater dividends.

3. Expanding Business: Older, larger businesses with a track record of stability and well-established business practices are generally more likely to pay dividends—and offer higher dividend yields—than smaller, more recent businesses.

Reinvesting profits instead of paying dividends is the preferred strategy for growth stocks, which are swiftly and geometrically increasing their earnings and revenues.

For that reason, dividend investors are far less likely to allocate growth equities to their portfolios.

4. Business Foundations: While high dividend yields could be alluring, they might also indicate that a business is having issues. When the stock price drops as a result of a decline in the company's earnings or a drop in market mood, there may be a greater yield.

Occasionally, financially troubled businesses will raise dividends in an effort to draw in more capital and raise returns. But the dividends may not last if the business can't turn things around and keep paying out large sums of money.
 

Dividend yield vs. dividend payout ratio

When comparing corporate dividends, it is important to note that the dividend yield presents the simple rate of return as cash dividends to shareholders. However, the dividend payout ratio represents the company's net earnings paid out as dividends. 

While the dividend yield is the more commonly used term, many believe the dividend payout ratio is a better indicator of a company's ability to distribute dividends consistently in the future. The dividend payout ratio is highly connected to a company's cash flow. The dividend yield shows how much a company has paid out in dividends over a year. The yield is presented as a percentage, not as an actual rupee amount. This makes it easier to see how much return the shareholder can expect to receive for every rupee they invest.
 

Is a high yield always best?

The biggest misconception about dividend stocks is that a high yield is still good. Many dividend investors choose a collection of the highest dividend-paying stock and hope for the best. For several reasons, this is not always a good idea. 
    
A dividend is a percentage of a business’s profits that it pays to its shareholders in cash as its payout ratio. Any amount paid out in a dividend is not reinvested in the business. If a business is paying shareholders too high a percentage of its profits, it may be a sign that management prefers not to reinvest in the company, given the lack of upside. Therefore, the dividend payout ratio, which measures the percentage of profits a company pays out to shareholders, is a key metric to watch. It is a sign that a dividend payer still has the flexibility to reinvest and grow its business. 

Some market sectors have a standard for high payouts, and it's also part of the sector's corporate structure. Real estate investment trusts (REITs) and master limited partnerships (MLPs) are two examples. These companies have high payout ratios and dividend yields because their structure is ingrained.
 

The bottom line

Many stocks pay dividends to reward their shareholders with sound financial footing. The dividend yield measures the number of a company's dividends relative to its share price. High-yielding dividend stocks can be a good buy for some value investors. Yet, they may also signal that a stock's share price has recently fallen by quite a bit, making the legacy dividend comparatively higher than the share price. A high dividend yield could also suggest that a company is distributing too many profits as dividends rather than investing in growth opportunities or new projects.