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