When it comes to picking stocks, one of the most critical ratios investors need to pay attention to is the dividend yield. But how exactly can investors evaluate the dividend yield of different stocks and compare it? What determines a good dividend yield for a stock?
In this guide, we will go over some of the most critical factors you need to consider when determining if a dividend yield on a stock is good or not.
What is a dividend yield?
The dividend yield of a stock is the percentage of the stock price that is paid yearly to shareholders in the form of dividends. Therefore, the dividend yield represents the income from stocks in the form of dividends relative to the stock price.
The dividend yield is expressed as a percentage, indicating the income a stock will generate.
Dividend yield formula
To calculate the dividend yield of a stock, all you have to do is to divide the dividend paid per share by the current price per share, and you will easily calculate the dividend yield. Keep in mind that as stock prices move up and down, the share price will constantly fluctuate and will affect the dividend yield.
Dividend Yield = Dividend Per Share / Price Per Share
Dividend yield example
Let’s consider a company whose stock price trades at $10 a share, with a quarterly dividend of $0.25. This means that the stock pays $1 in dividends every year. Therefore, its dividend yield is 10% since $1 is 10% of the share price of $10.
What does a dividend yield indicate?
Understanding and analyzing the dividend yield of a stock is crucial to picking the right high-dividend stocks and avoiding value traps. Here is what the dividend yield of a stock indicates:
Investors often use the dividend yield of a stock to gauge the risk of a company. When a stock has a high or very high dividend yield, that is often a sign of risk because market participants are not willing to invest in the stock despite its high dividend yield.
This means that the company is facing some hurdles or that the dividend may not be safe or sustainable. In the same way, a stock with a low dividend yield signals that the risk of the company halting or reducing its dividend is low, and therefore investors are more willing to invest in the stock.
Besides risk, investors can also understand how the company and its management and board intend to create shareholder value. While some stocks will not pay dividends, like Berkshire Hathaway, for example, but will conduct buybacks, other companies are known for paying consistent and growing dividends over time.
Choosing stocks is not only based on choosing the ones that will go up but the ones’ whose shareholder value creation aligns with your goals. For investors looking to get extra income from their stock portfolio, dividend stocks are ideal, but for other investors, it might not be the case.
Another important factor when considering the dividend yield of a stock is understanding how it influences the stock price. If you consider two identical companies with the same revenues and earnings, but one pays a dividend, and the other doesn’t, how will their stock prices differ?
In theory, the stock that does not pay a dividend will have a higher stock price over the long term because the company is keeping more cash on its balance sheet than a company that is constantly paying a dividend. So it is important for investors considering a good dividend yield to be aware of how dividends can impact stock prices.
The risk-free rate is a financial term used to describe the expected return without risk, and it is usually the treasury yield of the 10-year treasury. When analyzing dividend stocks and determining whether or not the dividend yield is good, we always need to consider the current risk-free rate. If a stock has a dividend yield above the risk-free rate, then it usually carries a considerable risk because you are getting rewarded for the extra risk.
When a stock has a dividend yield that is lower than the risk-free rate, you will have to consider the payout ratio. A stock with a low payout ratio can have a dividend yield lower than the risk-free rate and still be considered a risky investment.
What is a high and low dividend yield?
While determining what a low and high dividend yield is depends on the risk-free rate, or in other words, the current interest rate environment, a dividend yield up to 3% is considered low, and above 5% is considered high.
While this is just an abstract way of analyzing the dividend yield of stocks because it is directly related to the interest paid by government bonds or treasuries.
Understanding the relationship between bond yield and dividend yields
Bonds and stocks are deeply interrelated, and when investors consider putting their money to work, they will consider the yield of bonds and stocks. When interest rates are higher, bond yields are naturally higher, and this usually pushes investors to seek safety and invest in bonds rather than stocks.
If investors choose bonds instead of stocks, stock prices tend to either go down or maintain at the same levels, while earnings and dividends may increase, which means that dividend yields tend to increase when bond yields are higher.
What does a low dividend yield mean?
A low dividend yield can mean a few things:
The stock is very safe
Safe stocks and well-established companies with an excellent track record tend to have lower dividend yields because they command a higher valuation. The relationship between valuations and the dividend yield is critical to understand because it is directly related.
The company is still reinvesting its earnings
If a stock has a low dividend yield, that can also mean that the payout ratio is low, or in other words, the amount of earnings the company is choosing to distribute among its shareholders is low. This can happen for several reasons, but it is usually because the company is still reinvesting in its business.
The company constantly increases its dividend
Companies that increase their dividend regularly tend to have lower dividend yields because investors are willing to pay a premium or a higher stock price for a company constantly increasing its dividend.
The company is buying back its stock
A company may also choose to conduct a buyback program instead of paying its earnings in the form of dividends, and this can also explain why the dividend yield is low. Suppose a company is taking part of its earnings to distribute dividends and buy back its shares. In that case, obviously, the dividend yield will be lower than if the company chooses just to pay a dividend.
Stock price and valuation are high
Finally, if the stock price or the valuation is very high, the dividend yield might be low. You have to remember that the dividend yield is based on the current stock price, and while the dividends paid to shareholders can be a large percentage of the total earnings if the stock price is very high, the dividend yield will be lower.
What does a high dividend yield mean?
The stock is risky
Stocks with a high dividend yield are often a sign of risk, especially if the dividend yield is around or above 7%. Such a high dividend yield reflects the company’s low valuation, which can only be justified by several investors selling the stock, and even shorting sometimes. When there is a slight possibility that a company goes bankrupt or sees declining financial metrics, the stock price reflects this, as well as its valuation.
This is why most of the time, when a stock has a high dividend yield, it is usually a risky sign.
The company distributes most of its profits
The dividend yield may also be high as a reflection that the company is using most of its earnings to distribute among shareholders in the form of dividends. Investors can also analyze this by checking the payout ratio.
The payout ratio allows investors to understand what percentage of the company’s earnings are being used to pay dividends. A stock with a low payout ratio and a high dividend yield will usually be riskier than a stock with a high payout ratio and a high dividend yield.
The company is not buying back its shares
The two main ways of rewarding shareholders are through dividends and buybacks, and oftentimes when a company is paying a large percentage of its earnings through dividends, it is a sign that it is not buyback its shares.
While this should not be a matter of concern for most investors, buybacks tend to be a tax-friendly way of rewarding shareholders.
The dividend is about to get cut or halted
If a company’s earnings are declining, and the dividend is at risk of being cut or halted, the dividend yield can be higher for a short period of time. This is a common trait of companies struggling with declining margins, earnings, and sometimes revenues.
During the time when the company is still able to pay its dividend but is experiencing financial difficulties, the dividend yield can momentarily be higher. If the company happens to cut or halt its dividend, the stock price will plummet instantly when the news comes out.
Stock price and valuation are low
Finally, when the dividend yield is high, it can also be because the company’s valuation and stock price are low. When investors are fearful about the prospects of a company, they tend to sell its shares. This selling pressure on the stock inevitably affects its valuation, and when it gets lower and lower, the dividend yield tends to increase.
Can a dividend yield be too low?
Determining whether a dividend yield is too low depends on the type of investment goals you have. For example, an investor that is retired and keeps a diversified portfolio of dividend stocks to generate an additional income might require a certain dividend yield to invest in a stock.
On the other hand, an investor that is focused on the capital appreciation and is not worried about the income received through dividends might not consider a dividend either low or high. While the dividend yield of a stock can be too low, it is always dependent on the investor, its financial goals, and the type of stock he or she chooses to invest in.
Are low dividend yield stocks worth it?
While low dividend yield stocks may seem unattractive because they are not paying a lot in dividends, they can be great investments over the long term, especially if the company keeps raising its dividends. If you hold a stock with a low dividend yield over a long period of time, and the dividend keeps going up, the yield generated based on your cost will justify the investment.
It is also important to note that each stock should be analyzed and considered individually without putting too much emphasis on a single financial metric like the dividend yield. Unless you are a retiree looking for an additional income to support your lifestyle, the dividend yield alone should not be the sole reason to invest in a stock.
Can a dividend yield be too high?
Usually, dividend yields above 7% signal that there are clear risks associated with the company, and this is something to be aware of. Whenever this happens, investors should carefully analyze the stock to make sure they understand the risks and that they are not overlooking potential problems. This is crucial to prevent you from losing money on high-dividend yield stocks.
Additionally, you should be extremely careful about stocks with a dividend yield over 10%. These types of stocks are usually a lot riskier, and while it is possible to make money with them, there is usually plenty of red flags that explain why the dividend yield is so high.
Are high dividend yield stocks worth it?
Certain high-dividend yield stocks are definitely worth analyzing and even investing in. However, investors need to be aware of the reasons behind the high dividend yield. If the risks surrounding the stock are overestimated, high dividend yield stocks can be a great investment.
Good dividend yield FAQ
What is a good average dividend yield?
The best way to determine a good average dividend yield is to compare the average dividend yield of the index the stock belongs to as well as the industry average dividend yield. This is the simplest way to compare at first glance whether or not a certain stock has a high or low dividend yield.
What does a 10% dividend yield mean?
A 10% dividend yield usually signals that there are several risks impacting the stock, and it is a reflection that inventors are fleeing and selling the stock. This typically pushes the valuation of the company lower, and it is a sign that the dividend might not be sustainable or the company is facing problems.
Is a 7% dividend yield good?
A 7% dividend yield is typically considered high, and it is a sign that the stock could be facing some hurdles. This also depends on the average dividend yield for the index and other companies in the same industry.
Is 4% dividend yield good?
A 4% dividend yield is usually a solid signal that the company is healthy and is paying a good chunk of its earnings in the form of dividends. Stocks with a 4% dividend yield also tend to be safe.
What does a 2% dividend yield mean?
A 2% dividend yield often means that either the company is extremely safe and regularly increases its dividend or that it is still reinvesting its earnings in the business while paying just a small percentage of its earnings as dividends.
What is the average dividend yield for the S&P 500?
The simplest way to check the average dividend yield for the S&P 500 at any given time is by checking the Macro Trends website which has the full S&P 500 dividend yield history.
What is a good dividend yield for a portfolio?
A good dividend yield for a portfolio depends both on your risk level and your investment goals. If your investment goal is to receive income in the form of dividends from your stock portfolio, then a good dividend yield for a portfolio would be above 4%. If you are willing to take more risks, a dividend yield above 6% is also acceptable.
Finally, if your goal is not to generate income from your stock portfolio and you simply focus on stocks that go up, the dividend yield of your portfolio should not be a matter of concern.
For investors that are considering investing in dividend stocks, the dividend yield is one of the most important metrics to look for because it will help you to know how much you are expected to receive. It can also help you determine the overall risk of investing in the company, and it is a great way of assessing the possibility of losing money on a certain stock.
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