What is a Yield
Yield refers to the earnings generated and realized on an investment over a particular period of time, and is expressed in terms of percentage based on the invested amount or on the current market value or on the face value of the security. It includes the interest earned or dividends received from holding a particular security. Depending on the nature and valuation (fixed/fluctuating) of the security, yields may be classified as known or anticipated.
Formula for Yield
Yield is a measure of cash flow that an investor gets on the amount invested in a security. It is mostly computed on an annual basis, though other variations like quarterly and monthly yields are also used. Yield should not be confused with total return, which is a more comprehensive measure of return on investment.
Introduction To Dividend Yields
For example, the gains on stock investments can come in two forms. First, it can be in terms of price rise, like an investor purchases a stock at $100 per share and after a year the stock price increases to $120. Second, the stock may pay dividend, say of $2 per share, during the year. The total return is the appreciation in the share price plus any dividends paid, divided by the original price of the stock.
In the above example, total return will be
Total Return = (Price Increase + Dividend Paid) / Purchase Price
= ($20 + $2) / $100 =0.22 = 22 percent
However, yield does not include variations observed in the price of the security - like the changes in the share price from $100 to $120 - which is where yield differs from total return. Yield is a part of the total return generated from investing in and holding a financial security over a year. The general formula for calculating the yield is,
Yield = Net Realized Return / Principal Amount
where Principal Amount may vary depending on the type of yield being calculated, or the investment being considered.
Types and Examples of Yields
Yields can vary based on the invested security, the duration of investment and the return amount.
Yield on Stock Investments
For stock based investments, two types of yields are popularly used.
When calculated based on the purchase price, the yield is called yield on cost (YOC), or cost yield, and is calculated as,
Cost Yield = (Price Increase + Dividend Paid) / Purchase Price
In the above cited example, the investor realized profit of $20 ($120 - $100) resulting from price rise, and also gained $2 from dividend paid by the company. Therefore, the cost yield comes to ($20 + $2)/$100 = 0.22 = 22 percent.
However, many investors may like to calculate the yield based on the current market price, instead of the purchase price. This yield factor is referred as current yield and is calculated as,
Current Yield = (Price Increase + Dividend Paid) / Current Price
In the above example, the current yield comes to ($20 + $2)/$120 = 0.1833 = 18.33 percent.
When a company's stock price increases, the current yield goes down because of the inverse relationship between yield and stock price.
Yield on Bond Investments
Yield on bonds that pays annual interest can be calculated in a straightforward manner and is called the nominal yield.
For example, if there is a treasury bond with face value of $1,000 that matures in one year and pays 5 percent annual interest, its yield is calculated by
Nominal Yield = (Annual Interest Earned / Face Value of Bond)
= $50 / $1000 = 0.05 = 5%
However, yield of a floating interest rate bond, which pays a variable interest over its tenure, will change over the life of the bond depending upon the applicable interest rate at different terms. If there is a bond that pays interest based on say, (10-year Treasury yield + 2%), then its applicable interest will be 3 percent when the 10-year Treasury yield is 1 percent, and will change to 4 percent if the 10-year Treasury yield increases to 2 percent after few months.
Similarly, the interest earned on an index-linked bond, which has its interest payments adjusted for an index, like such as the Consumer Price Index (CPI) inflation index, will change as the fluctuations in the value of the index.
Yield to maturity (YTM) is a special measure of the total return expected on a bond each year if the bond is held until maturity. It differs from nominal yield which is usually calculated on a per-year basis, and is subject to change with each passing year. On the other hand, YTM is the average yield expected per year and the value is expected to remain constant all throughout the holding period till the maturity of the bond.
The yield to worst (YTW) is a measure of the lowest potential yield that can be received on a bond without the possibility of the issuer defaulting. YTW indicates the worst case scenario on the bond by calculating the return that would be received if the issuer uses provisions including prepayments, call back, or sinking funds. This yield forms an important risk measure and ensures that certain income requirements will still be met even in the worst scenarios.
The yield to call (YTC) is a measure linked to a callable bond - a special category of bonds which can be redeemed by the issuer prior to its maturity - and YTC refers to the bond’s yield at the time of its call date. This value is determined by the bond’s interest payments, its market price and the duration till the call date as that period defines the interest amount.
Municipal bonds, which are bonds issued by a state, municipality or county to finance its capital expenditures and are mostly non-taxable, also have a tax-equivalent yield (TEY). TEY is the pretax yield that a taxable bond needs to have for its yield to be same as that of a tax-free municipal bond, and it is determined by the investor's tax bracket.
While there are a lot of variations for calculating the different kinds of yields, a lot of liberty is enjoyed by the companies, issuers and fund managers to calculate, report and advertise the yield value as per their own conventions. Regulators like Securities and Exchange Commission (SEC) have introduced a standard measure for yield calculation, called the SEC yield, which is the standard yield calculation developed by SEC and is aimed at offering a standard measure for fairer comparisons of bond funds. SEC yields are calculated after taking into consideration the required fees associated with the fund.
Mutual fund yield is used to represent the net income return of a mutual fund, and is calculated by dividing the annual income distribution payment by the value of a mutual fund’s shares. It includes the income received through dividend and interest that was earned by the fund's portfolio during the given year. Since mutual fund valuation changes everyday based on their calculated net asset value, the mutual fund yields are also calculated and vary with the fund’s market value each day.
Along with investments, yield can also be calculated on any business venture. The calculation retains the form of how much return is generated on the invested capital.
Yield as an Investment Indicator
Since a higher yield value indicates that an investor is able to recover higher amounts of cashflows in his investments, a higher value is often perceived as an indicator of lower risk and higher income. However, care should be taken to understand the calculations involved. A high yield may have resulted from a falling market value of the security which decreases the denominator value used in the formula and increases the calculated yield value even when the security’s valuations are on a decline.
While many investors prefer dividend payments from stocks, it is also important to keep an eye on yields. If yields become too high, it may indicate that either the stock price is going down or the company is paying significantly high dividend, or both. Since dividends are paid from company’s earnings, higher dividend payouts indicates that company is having higher earnings, which should ideally lead to higher stock prices. Higher dividend with higher stock price should lead to a consistent or a marginal rise in yield compared to those observed in the previous period. However, a significant rise in yield without rise in stock price may mean that company is paying dividend without too much rise in earnings, and that may indicate possible problems in near future for the company’s business.
The Bottom Line
Yield is only one of the several factors that investors look for while assessing a business, company or return from an investment. Yield alone may not be the ideal, single factor based on which investment decisions should be taken. A detailed check on the past patterns on how the yield value has been moving in recent times, and a comprehensive look at the earnings, capital employed/invested, market price movements and their use in calculating the yield is important before basing the investment judgments on yield.