What Does a Stock’s Dividend Yield Mean?
Dividend yield on a stock means how much dividend income you will likely receive relative to the current price of the stock. It is the ratio of a stock’s annual dividend payment compared to its current price. However, dividend yield can, at times, be misleading to the average investor looking to invest in dividend-paying stocks. Learn more about dividend yields in this article.
How is Dividend Yield Calculated?
The formula for calculating dividend yield is: Total annual dividend payments divided by the stock price.
For example: If the price of a stock is $100 per share and it pays a $1 dividend each quarter, then it is paying a dividend of $4 per year. The $4 annual dividend divided by the $100 stock price results in a 4% dividend yield.
Dividend Yield vs. Dividend Rate
You may come across the term dividend rate. Dividend rate is just another way to say “dividend,” which is the dollar amount of a dividend paid out by a dividend-paying stock. While both dividend yield and dividend rate are useful for investors to know, the dividend rate does not readily tell you if the dividend provides you with more income relative to the company’s stock price and compared to other stocks (unless you also account for the current price of each stock to calculate the dividend yield). Therefore, dividend yield is most often quoted rather than the dividend rate.
Dividend yield as a percent measurement is directly comparable to the dividend yields of other stocks.
How Dividend Yields Can Be Misleading
Investors should not naively purchase a dividend-paying stock solely because it has a high dividend yield. Here are some of the ways dividend yields can be misleading to the average investor:
- Dividend yields are not set in stone. Dividend yields can vary widely for some companies as they may determine their dividends on quarter-by-quarter cash flow availability, or may at some point in the future reduce or eliminate their dividend as their financial position changes.
- Dividend yields are inversely related to share price. Therefore, an increase in dividend yield can be a bad thing if it is solely driven by a decline in the share price.
- A high dividend yield can be a “dividend trap” where higher, possibly unsustainable, dividends are paid to inflate the yield, to lure investors to an underperforming company with poor management.
Don’t invest in a dividend-paying stock based on its dividend yield only. Other things to consider include the stock’s dividend payout ratio (which shows how much of a company’s after-tax earnings are paid out as dividends), dividend payment history which can demonstrate the stability and reliability of the dividend, and stock price performance, to name just a few.
For long-term investors, especially those seeking a reliable stream of income, investing in a company that pays sustainable dividends can be more important than investing in a company that pays a high dividend yield that may not be sustainable. Depending on the level of income that you are striving for, it may make sense to invest in companies that have a lower dividend yield, but are dividend growers, which may result in a more profitable long-term investment overall.
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This content is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this content should consult with his or her financial partner or advisor.