Understanding Dividend Yield: A Simple Guide
If you’re into investing in dividends like I am, you’ll find it helpful to explore different aspects of evaluating stocks. This week, we’re focusing on the dividend yield formula and what it can reveal about a stock or company.
The dividend yield formula is quite simple:
Dividend Yield = Annual Dividends Per Share / Price Per Share
In simpler terms, the dividend yield tells you, as a percentage, how much money you’d make just by owning the stock. Stocks make money in two ways: through price appreciation and dividend payments. Expressing dividend yield as a percentage is useful because it simplifies calculations. All you need to do is multiply the percentage by your portfolio balance to see your dividend income.
Given that stock prices fluctuate, it’s helpful to look at yields in two ways: current and forward yields.
Let’s take Johnson and Johnson (JNJ) as an example. If JNJ’s annual dividend is $2.64 and the stock price is $85.32, the yield would be:
$2.64 / $85.32 = 0.031 = 3.1%
So, if you bought any number of JNJ shares today and held them for a year, you’d earn 3.1% in dividend payments. However, note that the dividend yield formula only accounts for dividend payments and not the actual stock price changes, which remain uncertain.
While the formula is simple, analysts believe it provides deeper insights:
1. **High Dividend Yield**: A high yield might indicate a depressed stock price. If JNJ continued to pay $2.64 but its stock price dropped to $42, the dividend yield would exceed 6%. Reputable companies usually maintain high dividends only if they believe in their long-term recovery. To confirm, check the company’s dividend history. Consistent or increasing dividends over ten years can indicate stability. Also, consider forward earnings or payout ratios to determine if a high yield is a bargain.
2. **Low Dividend Yield**: A low yield could suggest an overpriced stock. If JNJ’s price shot up to $160 but the dividend stayed the same, it might mean the stock is temporarily overpriced. Examining the dividend payment history and forward earnings forecast can clarify if the market is overpaying due to hype. Broadly, some analysts believe a low overall dividend yield compared to previous years signals an overvalued market. For instance, the S&P 500’s dividend yield dropped from 6.7% in 1982 to 1.4% in 1998.
3. **Alternate Plans for Earnings**: A low yield might also mean the company has other uses for earnings. This isn’t necessarily bad. Companies might plan stock buy-backs, as Apple recently did, which usually indicates self-confidence and can lead to higher share prices. Alternatively, they might reinvest earnings to drive growth, much like Warren Buffett does with Berkshire Hathaway. Buffett reinvests earnings to boost the company’s performance and share price, offering potentially greater returns than a simple 3% dividend.
Understanding these nuances can help you make informed decisions about which stocks to invest in based on their dividend yield.
