What is the 'Dividend Yield'
A financial ratio that indicates how much a company pays out in dividends each year relative to its share price. Dividend yield is represented as a percentage and can be calculated by dividing the dollar value of dividends paid in a given year per share of stock held by the dollar value of one share of stock. The formula for calculating dividend yield may be represented as follows:
Yields for a current year are often estimated using the previous year’s dividend yield or by taking the latest quarterly yield, multiplying by 4 (adjusting for seasonality) and dividing by the current share price.
As an alternative for calculating dividend yield, you can use Investopedia’s own dividend yield calculator.
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BREAKING DOWN 'Dividend Yield'
Dividend yield is a way to measure how much cash flow you are getting for each dollar invested in an equity position. In other words, it measures how much "bang for your buck" you are getting from dividends. In the absence of any capital gains, the dividend yield is effectively the return on investment for a stock.
To better explain the concept, refer to the following dividend yield example. Suppose company ABC’s stock is trading at $20 and pays annual dividends of $1 per share to its shareholders. Also suppose that company XYZ’s stock is trading at $40 and also pays annual dividends of $1 per share. This means that company ABC’s dividend yield is 5% (1 / 20 = 0.05), while XYZ’s dividend yield is only 2.5% (1 / 40 = 0.025). Assuming all other factors are equivalent, then, an investor looking to use his or her portfolio to supplement his or her income would likely prefer ABC's stock over that of XYZ, as it has double the dividend yield.
Investors who require a minimum stream of cash flow from their investment portfolio can secure this cash flow by investing in stocks paying relatively high, stable dividend yields. Yet, high dividends may often come at the cost of growth potential. Every dollar a company is paying in dividends to its shareholders is a dollar that company is not reinvesting in itself in an effort to make capital gains. While being paid for holding a stock is attractive to many, and for good reason, shareholders can earn high returns if the value of their stock increases while they hold it. In other words, when companies pay high dividends it may come at a cost.
For example, suppose company ABC and company XYZ are both valued at $1 billion, half of which comes from 5 million publicly held shares that are worth $100 each. Also suppose that at the end of Year 1 the two companies both earn 10% of their value, or $100 million, in revenue. Company ABC decides to pay half of these earnings ($50 million) in dividends to its shareholders, paying $10 for each share for a dividend yield of 10%. ABC also decides to reinvest the other half to make some capital gains, raising the value of the company to $1.05 billion and appeasing its income investors. Company XYZ, on the other hand, decides to issue no dividends and reinvest all of its earnings into capital gains, thereby raising XYZ’s value to $1.1 billion, likely appeasing its growth investors.
If these companies continue these policies at the same rates and continue to earn 10% of their value during Year 2, investors holding shares of ABC will see even greater dividend payouts, earning $10.50 per share ($1.05B x 10% = $105M, $105M / 2 = $52.5M, $52.5M / 5M = $10.50) at the end of Year 2 for a dividend yield of 10.5%. At the end of Year 2, company ABC will be worth $1.155 billion and has continued to keep its income investors happy, but by the same time company XYZ will be worth $1.21 billion. If these policies continue, by the end of Year 3 company ABC will be worth $1.213 billion and company XYZ will be worth $1.331 billion. Both companies are growing in value exponentially, but XYZ is growing at double the speed of ABC and will reach double its original value during Year 8, whereas ABC will do so in Year 14. By the end of Year 10, ABC will be worth $1.706 billion and XYZ will be worth $2.594 billion, or 52% more than ABC. Though this example is very simplified and an unlikely situation, it illustrates the drawbacks for a company that may accompany high dividend payments.
When companies pay high dividends to their shareholders, it can indicate a variety of things about the company, such as that the company might currently be undervalued or that it is attempting to attract investors. On the other hand, if a company pays little or no dividends, it may indicate that the company is overvalued or that the company is attempting to grow its capital. Certain companies in particular industries, when they are well established and steady-earning, often have good dividend yields even though they are not undervalued. Banks and utilities often fall into this category.
While a company may pay high dividends to its shareholders for a time, this may not always be so. Companies often trim their dividend payments or stop them altogether during hard economic times or when the company is experiencing hard times of its own, so one can rarely rely on consistent dividends on a permanent basis.
One can extrapolate information about a company’s dividend payments to estimate a company’s future dividends, either by using the most recent annual dividend payment or by taking the most recent quarterly payment and multiplying by 4. This is often referred to as the “forward dividend yield,” although one should use it with caution, as estimates of future dividend payments are inherently uncertain. One may also compare dividend payments relative to a stock’s share price over the past 12 months to better understand the history of its performance, and this is often referred to as the “trailing dividend yield.”