As part of my love affair over the last year with investing in dividends, I’m going to continue to introduce posts that focus on one particular aspect of evaluating a particular stock prospect. So this week, we’ll be looking specifically at the dividend yield formula and what it can tell us about the stock or company.
If you’d like a few other posts to read about stock evaluation, here are some of the topics we’ve covered in the past:
- How to Read Stocks and Evaluate Their Basic Metrics
- Can the Dividend Payout Ratio Help You Pick a Good Stock?
What is the Dividend Yield Formula?
Unlike a lot of other metrics, the dividend yield formula is actually very straightforward. It is calculated simply as follows:
What Does This Tell Us?
In a nutshell, the dividend yield tells you (in percentage form) how much money you’d make from simply owning the stock.
Remember that stocks basically make you money in one of two ways:
- They either go up in value (called capital gains)
- They pay you a portion of the company’s earnings (called dividends)
People often find it more helpful to express thus number as a percentage rather than a fixed amount because then you don’t have to factor in how many shares you own. You then just have to multiply the percentage against your portfolio balance to find out how much money you’ll make in dividend payments.
Because the stock price changes often, it is helpful to look at yields in two ways:
- Forward dividend yield: Uses the annualized first dividend payment / current stock price.
- Trailing dividend yield: Uses the annualized last dividend payment / current stock price.
To understand this concept a little better, let’s pick a company at random and apply our formula. For my example, we’ll take a look at Johnson and Johnson (stock ticker JNJ):
From other information that we can gather (on Yahoo Finance), we see how this gets calculated:
$2.64 / $85.32 = 0.031 = 3.10%
Therefore, if you were to buy 1, 10, or even 1,000 shares of JNJ today and held them for a year, you’d make 3.1% in dividend payments alone.
But remember that the dividend yield formula isolates ONLY what happens with the dividend payments. What’s going to happen to the actual price of the stock and the money you invested (called the principal) is completely unknown. It could go up (hopefully), or it might go down. This is part of the risk you take on and evaluate before actually buying any stock or investment.
Other Things the Dividend Yield Tells Us:
So on the surface you can see that the dividend yield formula is pretty straightforward. But the reason it’s being highlighted is because analysts believe there is more to it than what you see on the surface.
1. A high dividend yield could indicate that the stock price is depressed. For example, let’s say JNJ continued to pay $2.64, but for whatever reason their stock price dropped to $42! That mean a dividend yield of over 6%. Usually most reputable companies don’t continue to pay out high dividends unless they believe they will make a comeback or turnaround. So if the company seems like a strong long term prospect, then a high dividend yield may indicate a bargain stock price.
To see if this is true, look back at the dividend payment history of the company. Has the company consistently paid out the same or higher dividends over a ten year (or more) stretch? Have they done so despite any price or market fluctuations?
The other thing you could look at to is what the forward earnings or forward dividend payout ratio will be. If the company really believes they will raise earnings and is still continuing to offer a good dividend payment, then perhaps the low price may really be a bargain.
To point it out, this ideal is the premise of the book “Dividends Still Don’t Lie: The Truth About Investing in Blue Chip Stocks and Winning in the Stock Market “ by Kelley Wright. Basically as part of his Dividend Yield Theory, he believes that as stocks cycle up and down in price, by monitoring their dividend yield we can identify ample times to buy the stock when it is low in price and likely to go back up.
2. Conversely, a low dividend yield may indicate the stock is over-priced. If JNJ’s stock price were to jump up to $160 but their dividend payment stayed the same, that could indicate that stock is drastically overpriced. Usually this is temporary and followed by a setback in price.
Similar to Number 1 above, look at the dividend payment history and forward forecast for earnings. If there is nothing special going on here, then the market may just be over-paying for some short term hype.
It may be interesting to note that for the economy as a whole, some analysts claim that the low overall dividend yield when compared to what it was in years before is an indication that the entire market is drastically overvalued. To give you an idea, in 1982 the dividend yield on the S&P 500 Index was 6.7%. Over the following 16 years, the dividend yield declined to just 1.4% in 1998.
3. If you don’t believe that the company is over-priced, then a low dividend yield could also just mean that the company has other plans for those earnings. While it may sound like a bad thing to not receive some of those earnings in the form of a dividend payment, there may in some instances be a very good reason not to.
For example: Perhaps the company plans to do a stock buy-back. Apple recently announced that they would be doing this. Stock buy backs by a company are usually a good thing because it means that 1) the company has faith in itself and 2) there are fewer outstanding shares. Both of these will generally result in a higher share price.
In another example, consider the fact that Warren Buffett, arguably one of the best investors of our time, does not pay dividends to the shareholders of his company Berkshire Hathaway. Why? As he explains in his annual letter to the shareholders, Warren chooses to reinvest the earnings of his company back into the performance of the company itself so that it can continue to perform and grow in share price. Which would you rather have: A 3% dividend payment or the opportunity to have one of the greatest investors in the world work on making the price of the stock you hold go up while you get richer?
Readers – As you can see, even though the dividend yield formula is simple, it can reveal a lot about what is going on with a stock. How do you use the dividend yield to your advantage?
Disclaimer: I own shares of JNJ.
- My Dividend Stock Portfolio Update – May 2013
- Getting the Highest Dividend Stocks Using the Dogs of the Dow
- Book Review: “The Little Book of Big Dividends” by Charles B. Carlson
Image courtesy of MMD
[email protected] says
Good explanation of dividends MMD. I don’t have a problem with dividend paying stocks and I think they add a certain level of comfort to a portfolio. I’m just not convinced dividends are the best way to reward shareholders.
In some cases a dividend payment isn’t the best way to reward shareholders. Like I mentioned in the post, to use the earnings to do a stock buy back could be way more beneficial to the stock value and long term prospect. However, at some point when I will be relying on the dividend payments for income, I’ll probably care less about the stock price appreciation and more about the actual dividend payment since that will be what lines my pockets.
Nice explanation. I learned to love dividend paying stocks and as I invest in them I can see myself how powerful investment they are. You get price appreciation as well as dividend. You beat the market just by this.
Thanks Martin. The more I learn about them, the more I want to make them my only type of stock investment. What’s better than the strong potential for a stock price to go up? The fact that they are also willing to pay me a guaranteed 3 to 4% just for being a part owner. Sounds good to me!
[email protected] says
Great mini case study – very clear. Thanks for the information!
Thanks Mike! I hope it helps.
[email protected] says
The example you used of Johnson and Johnson paying 3% in just dividends alone was killer. In a world were people are happy to settle for a 1% return on their money in money market and certificates of deposit accounts, a 3% return would be great compared to those.
Thanks Zimmy. The only thing better than the prospect of a strong company stock increasing in value is when they pay you a somewhat guaranteeing sum of money on top of it just for participating. Even though savings accounts have their place, this makes it hard to turn back to CD’s or MMA.
I worked for JNJ for over 5 years, and during that time, I invested heavily in to JNJ stock. As a result, I make a nice dividend income which I reinvest every year.
Based on what Mr. Kelley believes, is AAPL a good stock to own or add more to now with the higher divided yield?
I am a big believer in investing for the dividend income. I also believe that you can’t go wrong if you invest in companies with over 100 years of history with history of dividend increase for at least last 10 years.
Yes, with AAPL increasing their dividend yield but their price is going down relative to months past, Mr Kelley’s theory may suggest in general that this is probably a good time to buy. However, usually his theory is more applicable to companies that have a long history of dividend yields. That way you have history to look back on and explore the patterns. In the case of AAPL, they have not always paid dividends. So this may be a gray area…
I’m starting to find that if you stick with the Dividend Aristocrats (those that haven’t decreased their payments in 25 years) that you will have a much easier ride to the top as opposed to messing around with other stocks. You are right that if there’s anywhere you should bet your money, its on companies that have a proven track-record and can afford to payout to their shareholders.
Shawn James @ Forex News says
That was so interesting to read and easy to understand. I love this simple mathematics since my school days and if it has to be done for investments and returns it becomes even more interesting.
I also look at current dividend yield in comparison with a stocks historic yield to see if its over or undervalued. A higher yield relative to what a stock has traded on in the past may suggest undervaluation, a lower yield may suggest overvaluation.
Good point to add. I suppose that the comparison of those two ratios would make the actual stock prices and actual dividend payments somewhat irrelevant at that point, which would be all around easier to interpret.