The Pros and Cons of Using a Dividend Yield

Introduction

A dividend yield, sometimes referred to as the 'yield on cost', is a tool used by investors to determine the profitability and returns of an investment. It is calculated by dividing the total dividend per share by the price of the stock. It is often used to compare different stocks or measure the performance of a portfolio.

The dividend yield can be a great way to measure the potential performance of a portfolio, however, there are both pros and cons to be taken into consideration. In this blog post, we'll look at the various benefits and drawbacks of incorporating a dividend yield into your investment strategies.

Pros of Using a Dividend Yield

Investors often use a dividend yield as a metric to measure the return on their investments. The dividend yield is calculated by dividing the sum of dividends paid annually by the current stock price. Coming up are the pros of using a dividend yield.

Can Help Measure the Return on an Investment

Using a dividend yield is one approach investors can use to calculate the return that an investment will give. This result can be helpful when comparing investments from different companies. Moreover, dividend yield reflects the dividend income that investors can acquire from a stock.

May be Able to Predict the Performance of a Stock

Understanding the dividend yield of a stock can give insight into the underlying performance of a company. As the dividend yield increases, the performance of a stock is generally better than when the dividend yield is low. Therefore, by observing the dividend yield, investors can get an indication of the income to expect.

On the other hand, by noting on changes in the dividend yield, investors can be alerted to possible new market opportunities while also allowing them time to adjust their portfolio and their investments.

Cons of Using a Dividend Yield

Appropriately evaluating a stock's performance is the key to the successful management of any investment portfolio. With that in mind, here are the two main drawbacks of using the dividend yield as part of a metric for assessing stocks:

May Provide an Inaccurate Representation of the Stock's Performance

The dividend yield only takes into account the dividend and does not consider capital gains from stock price appreciation. Comparing the dividend yield of two stocks is a relative exercise, and a higher dividend yield does not necessarily indicate higher absolute returns. In addition, stock price may at times be artificially inflated due to one-time events that would not affect the fundamental value of the stock, such as asset sales or massive stock buyback announcements. These events may result in a higher dividend yield but do not necessarily reflect an increase in the intrinsic value of the stock.

Not All Stocks Pay Dividends, which May Make Yield Calculations Impossible

The dividend yield of a stock is determined by dividing the annual dividend amount by the current share price. Therefore, stocks that do not pay dividends have an undefined yield which cannot be calculated. This also makes dividend-yielding stocks and non-dividend-paying stocks incomparable. In addition, many young, fast-growing companies do not pay a dividend and instead reinvest their earnings into the company, making dividend yield calculation impossible.

Additional Considerations

When it comes to evaluating a dividend yield, investors need to be aware that the yield data can change quickly and may not be up to date. Such yield figures can vary depending on the time the metrics are evaluated. Companies often have a tendency to change the dividend amount and payout date several times throughout the year, so investors should be sure to account for those changes and track their investments regularly.

Reinvested dividends can also have an impact on the dividend yield. Since dividend payments are often reinvested in the stock of the same company, these can lead to Dilution of Earnings or Reduced Cash Flow or even both in some cases. Investors who reinvest their dividend payments should be aware and adjust their dividend yield accordingly.

An additional factor to consider is that dividend yields only provide a snapshot in time and may not accurately reflect the company’s overall financial performance. Therefore, investors should take care to research the company’s financial history and overall prospects for growth when considering their dividend yield.

How to Calculate a Dividend Yield

In finance, a dividend yield is the measure of how much a company pays out in dividends each year relative to its share price. Dividend yield is an important factor used to evaluate potential stock investments. To accurately calculate dividend yield, investors must first determine the company's annual dividend per share, then divide the annual dividend per share by the current stock price.

Calculate a Company's Annual Dividend Per Share

To begin calculating dividend yield, investors must know the company’s annual dividend per share. The company’s annual dividend per share is typically listed in the company’s financial statements, but can also be found online through websites such as Yahoo! Finance or Google Finance. Alternatively, investors can multiply the company's recently declared or paid dividend per share by the number of times it is paid out within a year. For example, if a company pays out a dividend of $0.50 per share every quarter, the annual dividend per share would be $2.00.

Divide Annual Dividend Per Share by Current Stock Price

Once the company’s annual dividend per share is determined, investors can then divide the annual dividend per share by the company’s current stock price. For example, if a company’s annual dividend per share is $2.00 and its current stock price is $40.00, its dividend yield would be 5%. The calculation would look like this: dividend yield = ($2.00/$40.00) x 100 = 5%.

By accurately calculating a dividend yield, investors can make better informed decisions on their stock investments. Keeping a close eye on companies’ dividend yields can help investors buying stocks to achieve their desired returns.

Methods for Identifying Stocks with High Dividend Yields

One popular method for finding stocks with high dividend yields is to use a stock screener. A stock screener is a tool that allows users to easily identify stocks with desirable characteristics, such as dividend yields. With a stock screener, investors can input parameters that they are looking for and the stock screener will pull up stocks that meet their criteria.

The other popular method for finding stocks with high dividend yields is to analyze charts or graphs related to dividend yields. By examining the past dividend yield volatility of the stock, investors can make an informed decision on whether it may offer a higher return than other stocks. Additionally, investors can look at the past performance of the company’s share price in relation to dividend yield to determine if buying the stock is a wise decision.

Conclusion

When analyzing a stock and its potential for performance, a dividend yield can be a useful tool for investors. While a dividend yield can provide a quick snapshot into the performance of a stock, understanding the nuances of how it is calculated and the possibilities for what could influence it is key to avoiding potentially investing in a stock with a high dividend yield that may not be reliable or consistent. Identifying how a company’s payout ratio and other factors might create an abnormally high dividend yield is essential to making an informed investment decision.

In conclusion, dividend yields are a powerful tool that can be used to analyze a stock’s potential performance, but they can also be misleading if not properly understood. Prospective investors should educate themselves on how a stock’s dividend yield is calculated, and how factors such as the payout ratio can significantly impact what the yield appears to be. Doing the research ahead of time can go a long way in increasing the chances of investing in safe, profitable stocks.