FOOL SCHOOL
Valuation: Dividend Yield

January 14, 2002

This is the fourth article in our mini-series on valuation. Here we look at dividend yield.

A dividend yield is the percentage of a company's share price that it pays out as dividends over the course of a year. It is calculated as:

  Dividend Per Share
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  Current Share Price

The dividend yield expresses the annual dividend of a share as a percentage of return on investment at the prevailing market price. Dividends are paid 'net of basic rate income tax'. This means that if you pay tax at the basic rate, you have no further tax to pay. But if you are a higher-rate taxpayer you will have additional tax to pay. Our tax centre has more details on this.

Most profitable companies in the UK pay regular dividends to their shareholders. Some pay more than others, depending on their growth prospects, cash balances and dividend policy. Newer companies still looking to expand will tend to pay low dividends. Mature companies with less room to expand will tend to pay high dividends. 

You will find that the majority of companies wil try to increase their dividends each year, usually in line with any profit increase. However, they are often reluctant to cut their dividends if their profits fall. Therefore, if you have a broad portfolio of shares you are likely to find that the annual dividend income you receive is a lot less volatile than the total value of your holdings.

Like other valuation measures you can either look at the historical figures (either the latest completed financial year or the last 12 months) or forecast figures. However, forecast dividends are not quite as easy to get hold of as forecast earnings.

A high dividend yield may indicate that the share is cheap. You could classify a high yield as one that is more than 50% higher than the stock market average. Currently, the UK market is 'yielding' around 2.5%. This is the average dividend pay out of all companies traded on the London Stock Exchange. That would make companies paying out 3.75%+ high-yielders. Some investing strategies use dividend yield as one of their key selection measures.

Caution, as ever, is required. Most yields that are quoted are historical and it does not mean that the same level of dividends will be paid in future. Whilst brokers may be able to predict forecast increases it is lot harder to predict cuts. If a company hits really bad times it may suspend its dividend payments altogether. If its share price falls dramatically, because investors realise it is struggling, this can increase the historical yield, perhaps even into double figures. Treat all such companies with extreme care as this often means that investors, as a whole, do not believe that the recent level of dividend payments will be maintained.

For more on this topic check out the High Yield Portfolio section of our Value Investing centre, this article and our guide to dividends.

Other valuation articles:
The PE ratio
The PEG ratio
Price to Sales
Return on Equity
Return on Equity and Goodwill
Uses of Return on Equity
Balance Sheet Basics
Discounted Cash Flow