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Dividend yield: the essential guide to understanding how it could make or break your investment portfolio

One of the most researched metrics for income investors is a company’s dividend yield, as it shows the potential income expected from purchasing shares of that company as a percentage of its share price.

A lack of understanding of the value of this metric can easily be the downfall of an income portfolio, especially by those new to investing.

In this article, we will be taking an in-depth look into what they are, how to calculate them, the benefits of this metric, and the pitfalls to be careful of to assist in the formulation of your own portfolio. 

What is dividend yield?

A stock’s dividend yield is the expected annual payment to shareholders expressed as a percentage of the stock’s price at the time it was calculated. This metric is useful for income investors as it can quickly give an estimation of the return on investment a stock should make through regular payments, without taking any capital growth into account. 

It’s important to note that a stock’s yield should not be considered to be set in stone, as it can fluctuate due to stock price movements within the market, or from the companies changing the value of their pay-outs. Their value may change on a weekly or even daily basis, so it is important (as with any investment opportunity) to do your due diligence and check to see if this is occurring frequently before you decide to invest in a company’s stock.

You may find it helpful to look at a company’s history to see how volatile the movement over the past few years has been. Investigate to find out what is causing the fluctuations (if any) in the company’s stock price and dividend value, as a stable dividend is usually more sought after as it is often considered more reliable by income investors. Stable dividend payouts can be found more frequently from established companies that have been consistently growing in value over sometimes many decades.

How are they calculated?

It may sometimes be better to learn how to calculate dividend yields yourself rather than relying on websites reporting them, as they may be less reliable if they are not frequently updated.

To avoid making investment decisions based on outdated information, you can calculate them yourself by using the dividend yield formula. 

Dividend Yield = Annual Dividends Paid Per Share / Price Per Share

This equation simply divides the annual dividends paid for each share, by the price per share of the stock.

As an example, if you had seen that a company you are interested in purchasing shares in has an annual dividend of £1 and the stock is currently valued at £30 per share, you would divide the amount by the value of each individual share. In this scenario, you would receive a yield of 3%. 

Are they calculated annually or monthly?

The annual yield is calculated upon the yields of every regular payment of the previous year.

The issue with using yield in this manner is that the value of a stock is used to determine the annual yield, so the annual yield may not be the best way to predict an expected income.

Calculating the yield of a stock on a monthly basis yourself using the formula above may provide a more accurate idea of how much you could stand to potentially gain from purchasing shares of that company. 

What is a good yield?

According to Mark Henricks of Yahoo Finance, stocks offering 4-6% are generally considered to have a good dividend yield, however, caution needs to be exercised when considering purchasing high dividend yield stocks. Companies with yields that far exceed the average in their sectors are possibly having cash flow problems, may be manipulating the stock price, or have had a large shareholder sell-off.

One way to see if a company is offering a higher or lower average dividend yield, is to compare it to companies of a similar size within the same sector. For example, the basic materials sector has an average yield of 4.92%, so when looking for a company’s yield within this sector, you can see whether they are offering above or below the average.

As a new investor, it is very easy to take the attitude of “the higher the yield, the better”, but this is not always the case. Due diligence should be exercised when purchasing stocks with the intent of earning income over the long term. A lower yield may initially look unappealing, but, if after research you find that the company has been increasing its dividend every year for the past 25 years, the smaller yield may now not be an issue. 

What effect do stock prices have?

Yields can change daily relative to the value of the stock they represent. As the value of a stock increases, its yield will often decrease, and vice versa. If the value of a stock were to suddenly double in value, the yield would halve, and so, if its value were to halve, the dividend yield would double. 

What are the average yields across industries?

Different industries tend to pay higher or lower annual dividends once averaged out. 

The list below is a breakdown of each industry.  

  • Basic materials industry: 4.92%

  • Financial services industry: 4.17%

  • Healthcare industry: 2.28%

  • Industrial industry: 1.76%

  • Services industry: 2.37%

  • Technology industry: 3.2%

  • Utility industry: 3.96%

Of course, it should be noted here, that a common method of minimising investment risk is to diversify your investment portfolio across multiple sectors, in the hopes that you can avoid any negative, industry-wide events.  

What are the benefits?

The main benefit of regular dividend paying stocks, is that they generate a stream of income to the investor, whilst maintaining the ability to grow in value. Some companies will offer cash dividends, which are a direct source of income straight to the shareholder, whereas others may offer payments in the form of additional shares within the company which can either be sold or held onto to further enhance their compounding effect.

Whilst a dividend-paying stock will often grow at a slower rate than a traditional growth stock (because the company is giving away some of its profits to the investors), the value of the underlying asset can still grow, increasing the monetary value of the individual shares.

They are also beneficial to investors during low volatility markets where growth investors may struggle to make a profit from buying or selling their shares.

An additional benefit is that the pay-outs are taxed at a lower rate than many fixed-income assets such as government or corporate bonds, allowing you to keep more of your profits.

Historically, stocks that pay dividends have outperformed stocks that do not during bear markets. Growth investors struggle to turn a profit when the value of the shares they own are falling in value, whereas an investor interested in regular payments may be more likely to hold onto shares of a stock that pays dividends, making them at least some returns during these times. 

Yield vs payout ratio

Having a clear understanding of the difference between yield and payout ratio is important, as one tells you how much return an investor can expect from purchasing shares, and the other tells you how much of a company’s net earnings are paid out as dividends.

The yield shows how much return (as a percentage) can potentially be expected after investing in a particular stock. The yield can change multiple times throughout the year or even month as the stock reacts to the changing economic landscape.

The payout ratio is quite different, this figure represents the ratio of a company’s net profit shared out to its investors in the way of payments. For reference, the FTSE 100 index has had an average payout ratio of 3.69% over the past 5 years. Both factors should be carefully considered when deciding on whether to purchase a particular stock for income, as when you combine the information presented from both factors, there is potential to uncover significant information about the performance of the underlying stock.

For example, if you were to only look at the yield of a company, you may see that they are paying an 8% dividend, which on the surface may appear as a great investment opportunity. However, if you were to then investigate the payout ratio and saw that 70% of the companies’ net profits were being paid out to its investors, this could be seen as a red flag, as most of the profit was being handed back out to investors instead of growing the company.

It could also be that the company has raised the yield of its shares to try to drive up interest and rescue a potentially struggling stock to increase its cash flow, which is an unsustainable practice. In the worst-case scenario, an ever-increasing dividend yield may indicate that many stockholders are selling their shares due to a declining share price, which inflates the yield percentage. 

The exception to this are stocks that follow a strict set of rules that require that they distribute a certain percentage of their profits back to their shareholders. The most common example of these are REIT (real estate investment trust) stocks, as they are required to pay back 90% of their annual profits to their shareholders. 

Should you invest in high-yielding stocks?

If you have fully investigated both the payout ratio and dividend yield of a company, you should be able to make a clear decision on whether a stock is offering a high yield because it is trying to artificially increase its stock price as it’s struggling financially, or whether it is obligated to because of its business structure.

Is this to say that you should never invest in stocks with higher dividend yields?

This question must be answered by the investor themselves as there are pros and cons to purchasing high-yielding stocks.

Longer-term investors may prefer lower-yielding stocks, as these are sometimes seen as being more reliable, whereas a short-term investor​ may prefer to accept the associated risk of investing in a higher-yielding stock if they require a greater sum of cash over the short term.  

The risks involved with purchasing high yield stocks explained in the previous section should be thoroughly investigated and considered before making any purchase. 

How often are dividends paid?

Understanding when and how often dividends are paid out can have a large impact on the growth rate of a portfolio. Whilst the yield may be useful as a guide to establishing the income potential of a stock, how frequently this amount is paid determines the rate at which a portfolio can benefit from compounding.

In the USA, it is common for most stocks to pay dividends to their shareholders on a quarterly basis, with the exception of some real estate stocks, which pay monthly.

In the UK however, it’s more common for large companies to make payments to their shareholders twice a year, or “bi-annually”, with one annual payment, and one interim payment. There may also be special payments made out to investors when a company has an excess of cash that isn’t required for the current growth model. 

There is also the exception of some UK real estate stocks that provide monthly payments, and a small number of stocks that pay a quarterly dividend. 

On the surface, you may think that it would be prudent to invest in US stocks over UK stocks if you are looking to take advantage of the compounding effects of monthly payouts. However, careful consideration needs to be paid to the amount of tax that you will be charged on the dividends paid if you are planning to purchase them whilst living in the UK, as the tax you will be charged may offset the benefits of doing so. 

Foreign companies may deduct the tax before paying to the shareholder, however before being paid into an account of an overseas investor, the country they reside in may tax the amount once again, effectively taxing the payment twice.

The UK has a double tax treaty with the US, which reduces the amount of foreign tax payable. In most cases, the tax paid by a UK resident on dividend earnings from a US stock is around 10-15% instead of the potential 30% you would usually be required to pay. 

A company can also decide at its own discretion to either decrease the yield of the dividends it pays or cut them entirely during times of hardship. They will most often do this to reinvest that money back into the company.     

Should you look for a growing yield?

Whilst it stands to reason that an investor may wish for every factor of their investments to increase, the dividend yield as a percentage may not need to be one of them.

It’s possible for it to stay consistently low if the main objective of that company is to re-invest its earnings into expanding the business. However, it is commonplace for very large companies to still offer an incentive for people to invest within their stock.

In this scenario, 1-2% could be considered a small yield, but it could still have investment potential as long as the company offering it is consistently growing its profits and increasing the amount paid on a consistent basis. 

A company continually increasing its dividend amount is an important factor to consider for the long-term investor, as this shows that the company continuing to increase profits and can afford to raise the dividend payment to its shareholders each year, which can imply the company’s dividend payments are consistent and sustainable for the future.  

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