The Dividend Yield is a financial metric that indicates the amount of dividend paid by a company per share divided by the market or traded price of that share. It is an indicator of the company’s profitability and strength of cash flow which it then passes on to its owners aka shareholders. It is an important metric to gauge the stability and strength of the company within its industry with strong and mature companies having a higher dividend yield as compared to their not so strong peers.
It is also an indicator of the company’s ideas or lack of for putting their capital to proper use. While not used directly for valuation of companies like other financial ratios, dividend yield nonetheless is an important metric to calculate and evaluate in order to shortlist as well as filter out companies depending on your investment goal and behavioral inclination. Let us try to understand this ratio with several examples across the industry.
Dividend Yield often quoted in percentage format (%) is given as follows:
Dividend Yield: (Total Annual Dividend Amount per share / Share Price) * 100
If we multiply both denominator and numerator by the total number of shares, we get dividend yield as:
Dividend Yield: (Total Annual Dividend Amount / Market Capitalization) * 100
The total annual dividend amount paid can be found in the cash flow statement. Total number of shares can be found in the income statement. Some companies pay a quarterly dividend. One can annualize it by taking the average of the dividend paid for all the quarters in the financial year and multiply it by 4.
This is applicable only if the company pays an even quarterly dividend which is the case with utilities and Real Estate Investment Trusts (REITs). For those that pay small quarterly dividend and a large annual one, need to consider the sum of the previous year only. Ultimately dividend yield calculations are often subject to errors and we shall explore this drawbacks in detail as we move forward.
Shareholders of any company are the owners of that company. As such, they have a right on the profits earned by that company. Dividends are a vehicle to distribute those profits to the owners/shareholders. However, a company also needs money to grow and that money also comes from the profits. Hence a call is taken to decide on how much portion of the profits is to be distributed to shareholders and how much is to be retained. That decision depends on the growth opportunities available to the company. Company management makes the decision in consultation with the board of directors to determine whether the new opportunities are to be pursued or the surplus profit is to be handed over to the shareholders.
From a shareholder point of view, dividend yield is a portion of the returns it can expect from its investments. For our investors who are familiar with investing in fixed income securities like bonds, bank fixed deposits or certificate of deposits, investors in fixed income securities earn an interest on their investment known as yield. This is their return on investment. Similarly for a shareholder, the dividend is a return on investment and the % return is known as dividend yield.
However unlike fixed income securities, dividend yield is neither fixed nor guaranteed. Generally dividend is paid by those companies who make a profit and is paid out from those profits. Exceptional cases always exist where a company has paid out dividends despite in loss or taken on a debt to pay that dividend. These activities are red flags and investors must deep dive into the company’s financials and operations as well as pay close attention to developments in the company.
However in most cases, dividends are paid by profitable companies and larger dividends are indicators of large companies with large profits. However this does not mean that all profitable companies pay out a dividend.
Dividend is decided on a case to case basis and as investors, you are to evaluate companies paying or not paying a dividend on a case to case basis merit as well. Small companies can pay out dividends and large companies may not. Stable mature companies may pay out but profitable yet growing companies may not. One cannot filter out companies just because they are or are not paying a dividend nor include them for the same reasons. If the company in consideration is not paying a dividend, evaluate why it is not doing so? Perhaps it has a growth opportunity or an acquisition in mind. Similarly evaluate if the company is giving a dividend.
Why is it giving a dividend if an opportunity exists? Is that not worth the money? Ideally, dividends should be the last resort for a company. The concept of Return on Capital comes into play. For e.g. a company generates a Return of 15% on its employed capital (Debt + Equity). It has to continue deploying money to continue to grow its earnings at 15% to maintain its Return. Giving away that capital via dividends instead of directing it towards growing its earnings is taking away share price growth from the shareholders. Most shareholders do not reinvest the dividend into stocks and instead choose to spend it or invest in low return investments like bonds. This is as good as losing money because you are taking money away from a high return asset to invest in a low return asset. Dividends however have their advantages which we shall look into below.
Dividends are a way to generate a regular income from your investments without compromising on wealth appreciation. Fixed income securities like bonds will provide you with a regular income but will not have any price appreciation and your money will lose value to inflation. Those looking to escape the ravages of inflation but at the same time generate a somewhat regular income can invest in high dividend yield stocks. Dividends also enhance returns for the investors. As per this paper dividends contributed to about 41% of the returns of S&P 500 from 1930-2020.
This is significant in that half of an investor’s returns are from dividends. However, as we have discussed, dividends are not guaranteed and investors need to evaluate the companies under consideration carefully to ensure regular dividends. One of the way to do so is to take a look at the longer dividend history of the company.
Dividend yields are often sector specific i.e. some sectors will on average have higher yields and some lower. Large stable non-cyclical companies tend to have a high dividend yield and give dividends on a regular basis. Utilities by their nature of predictable cash flows also tend to have a high dividend yield as well as provide regularity in dividend payments. To be safe, investors must look back at least 10-15 years of dividend history to see if the company has paid a regular dividend.
The company should have increased dividends every year but even if that increase has been missing in some of the years, the dividend itself should not be missing. An uninterrupted dividend payment history will ensure a high probability that the company will continue to pay dividends without fail and might even increase them. Let us look at the utility sector specifically at electricity transmission companies and their dividend yield.
All the electricity transmission companies have high dividend yields. That is because the business is pretty steady and not subject to demand fluctuations. People will continue to use electricity irrespective of the seasons or weather. Heating in winter and air conditioning in summer is common so are the usage of electric lights, water heaters and other appliances. The major cost for electricity companies is infrastructure which once in place only requires periodic maintenance. The operations and maintenance costs are also fixed and predictable. The sector is highly regulated and pricing is fixed.
Companies tend to have a monopoly in the region they operate i.e. they are the sole suppliers of electricity in that region so no competition. All of this contributes to a company which will provide regular dividends on a periodic basis with high probability. However as we had discussed before, dividend yield is neither an indicator of performance nor a way to evaluate companies suitable for growth. Another sector with stable demand, predictable growth and a duopolistic industry is beverages.
Coca Cola and Pepsi are dominant beverage companies in the world. Their market share is fixed and shifts ever so slightly. Dr. Pepper is a relatively new entrant founded in 2008 and is a growing company seeking to gain market share from the fixed incumbents. A common factor between both these sectors and for sectors having high dividend yield overall is that a high dividend yield is generally synonymous with low growth and reduced performance from stock price appreciation.
Dividends often come at the expense of growth of the company. Capital that could be used for growth is diverted towards paying the dividends. A company that can grow capital at 15% per annum is better off investing profits into the company rather than pay out dividends. That is why Berkshire Hathaway has never given out a dividend. Some of the famous, powerful and high growth companies have had next to no dividend and hence near zero dividend yield.
These are some of the largest companies in the world but have the potential to grow even larger and their profits are directed towards their growth rather than pay dividends. Dividend yield can also be misleading. A falling stock price can automatically increase dividend yield as the denominator in the formula is decreasing. Generally a continuously falling share price is indicative of some problem in the company and as such may cut or even stop dividend payments going forward. A high dividend yield must always be evaluated for any distress especially in sectors that are not known for paying dividends.
High dividend yield add a stability factor to an equity portfolio and provide a source of regular income. As such they should be a part of your portfolio especially for those who are nearing retirement and planning a portfolio for it. For young investors, they are better off investing money in fast growing companies than dividend paying companies since dividend paying companies are not synonymous with growth. High dividend yield should not be taken at face value. It has to be ascertained that the dividend yield is within the average range of the last 10-15 years as well as regular and appreciating.
Stock price should not be in a continuous decline and all fundamental factors must be vetted thoroughly to ascertain that the company business is sound. The company must ideally be using its profits for growth. Only after exhausting all growth opportunities, should the decision to pay dividend be taken. High growth sectors like technology or pharmaceuticals should ideally not be paying dividends. Companies having a high dividend yield in these sectors are hazardous and must not be touched with a long pole. Structure an equity portfolio with a certain ratio of growth companies to dividend paying companies and increase the weightage of dividend paying companies as you grow older.
Our premium membership allows you access to our vast repertoire of fair value calculators that will allow you to determine the fair value of the stock in consideration and determine its undervaluation/overvaluation. Markets tend to converge on fair value over time and an undervalued stock will soon find its market price rising to meet its fair value.
One can use Yahoo Finance to get fundamental data and use our free manual calculators below to get fair value of the stocks they are looking at. Alternatively our premium membership will do this job for you hassle free One can get our premium membership for as low as € 7.9 per month. Our sector Analysis tab will present you sectors currently having high dividend yield.
Once the high dividend yield sectors have been identified, deep dive into the sectors you think will continue to generate high dividend yield and then select the market leaders in that sector.
Dividend yield is a good indicator of size, quality and strength of the company when evaluated in the context of its sector. It is a good shortlisting as well as filter mechanism depending on the investment need and horizon. For those looking to generate regular income and at the same time keep their investment portfolio above the waters of inflation, dividend yielding companies are a good bet. There are drawbacks to it but they all range around erroneous data and calculations as well as mathematical anomalies.
Nonetheless it pays to deep dive into the reasons for the high dividend yields or lack thereof. Always remember that no single ratio is the holy grail of investment selection. One must build a consensus of various financial ratios like P/E, P/B, and ROE etc. alongside dividend yield in order to arrive at an investment decision. Alternatively, join our premium membership and we will do all of this work for you, providing you various fair values right on your very own premium dashboard.
Dividend yield companies are shortlisted on the basis of the risk profile and age of the investor. A young investor holds very little dividend paying companies instead focusing on the high growth companies which divert all their profits to further growth. An investor in his 50’s approaching retirmement will hold majority of his equity portfolio in dividend paying companies since this will stabilize the portfolio and at the same tmie ensure growth.
This transition has to happen gradually during the investor’s investment journey. Idea is to focus on sectors as a whole while selecting high dividend yields since companies in such sectors tend to have a monopolistic or duopolistic nature of business. Once the sector has been highlighted, other financial ratios can be compared to find the most undervalued stock relatively and invest in that from the consensus that has been built.
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