The Dividend yield ratio is a financial ratio that indicates what percentage of the current price of a company’s shares is paid as dividends on a yearly basis. The dividend yield fluctuates, as the price of the shares fluctuate. It could also fluctuate due to changes in the company’s dividend distribution policy.
What is a Dividend Yield?
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A dividend is a portion of a company’s net income that is distributed among shareholders. The amount of the dividend is often calculated as a percentage of the net income, which is known as the dividend payout ratio. While companies are not obligated to issue dividends, doing so is seen as a positive sign that the business is doing good. For this reason, investors estimate the dividend yield, as a way to determine how much of the current market price of the company will be received in the form of a dividend.
Therefore, the dividend yield is employed as a measure of credibility and financial healthiness. Companies that can show the consistent payment of a dividend throughout long periods of time are perceived as stable businesses that investors can rely on. A high yield indicates that the investor will receive a substantial portion of the price of the shares in the form of a dividend payment.
Dividend Yield Ratio Formula
The formula to determine the dividend yield is fairly easy:
DY = Annual Dividend / Price per share
Dividend Yield Equation Components
Annual Dividend: The amount of money that will be paid as dividend for each outstanding share.
Price per share: The current market price of the company’s stock.
There are some instances in which dividends are distributed in the form of additional shares in the company. These are known as stock dividends. In this case, the way to calculate the annual dividend would be to take the value of the dividend being distributed, and not the actual market price of the new shares.
Dividend Yield Calculation Example
Rock Industries is a business that manufactures heavy machinery for the construction industry. They are a highly reputed company with a market capitalization of nearly $3 billion and the company is highly favored by investors due to its policy of distributing a large percentage of its net income as cash dividends.
Currently, an analyst is trying to estimate the company’s dividend yield. In order to do so, he referred to the latest annual report, that shows that the business had a net income of $123 million. The company’s dividend distribution policy indicates that 40% of that net income will be paid in the form of cash dividends. Right now, the price of the company’s shares is $165 and it has 2.5 million shares outstanding. This means that the current annual dividend per share is $49.2.
With this information, the analyst can easily calculate the current dividend yield:
DY = $49.2 / $165 = 29.8%
This yield indicates that someone who invests in Rock Industries today, will obtain at least 30% of its investment back in the form of a cash dividend, if the company produces a profit next year as high as the one it produced this year.
Dividend Yield Ratio Analysis
Distributing a large percentage of a business’ net income as dividends has both its advantages and disadvantages. Dividends are taxed at both the corporate and the individual level, and at the income tax rate, which is higher than the rate applied to capital gains. This makes dividends the more expensive option through which shareholders can be compensated.
Additionally, a company that distributes a high percentage of its profits will have less resources to invest on future projects. This is an important element to take into account, especially if the business is growing. Since financing projects through equity makes them less risky, it is easier for a business to retain a higher portion of its earnings to grow, than stepping into leverage to finance its projects. For this reason, companies often find a balance between a satisfying dividend policy and a sufficient earning retention.
A low dividend yield though, is not a positive sign of a healthy business. Even though there are some businesses that have sustained no-dividend policies throughout time, as is the case of Berkshire Hathaway, the company owned by the billionaire investor Warren Buffett, distributing at least a small portion of the net income as dividend promotes trust and credibility.
On the other hand, stock dividends, as opposed to cash dividends, consist in distributing dividends in the form of additional shares of the business, to existing shareholders. This kind of dividends are right now not as common as they were in the past, yet some companies continue to follow this practice as a way to retain all their earnings. While it may seem logical if the business is growing, it is also a practice that tends to put shareholders in an uncomfortable position, as the money is automatically reinvested in the business without their actual consent.
Dividend Yield Uses, Cautions, Pitfalls
The price per share employed for the dividend yield formula should be carefully analyzed in order to make sure the calculation is accurate. Analysts often use the average price for the last 30 to 90 days.
On the other hand, while a high dividend yield tends to communicate financial strength, it could also lead the business to acquire debt to finance its projects. For this reason, a high dividend yield should be justified by the management team, in order to make sure it is a financially sound decision.
In some cases, businesses distribute a high portion of their net income just because they don’t have enough projects to invest their money in. In these instances, shareholders may be more benefitted by being able to put that money somewhere else, than leave it in the company where it will just sit in the business’ bank account.
Finally, a company that tends to change its dividend policy too often will not be viewed by the market as a reliable investment opportunity. As some financial valuation models rely on estimated dividend payments to calculate a company’s fair price, an erratic dividend policy may increase the difficulty of estimating the value of the firm, which will eventually lead analysts to flag the stock as a highly volatile one.