What Is a Dividend Yield and How Is it Calculated?

Learn how to correctly analyse a dividend yield and discover some of the best passive income investments in the stock market today.

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A stock’s dividend yield can signal lucrative income opportunities for patient investors. But how exactly does this metric work? How can investors correctly calculate it? And what are the advantages and disadvantages of using it during an analysis? Let’s explore!

What is a dividend yield?

The dividend yield represents the total dividend payouts given to shareholders as a proportion of the share price. It’s a helpful percentage metric that provides insight into the future income an investment can generate based on today’s stock price.

For example, a £1,000 investment made in a dividend stock with a yield of 4% means the investor can expect to earn £40 a year in passive income. Of course, this assumes the dividend payout remains unchanged throughout the year.

It’s important to remember that dividends are an optional payment for companies. When business is booming, dividend payments may increase. However, if operations are disrupted, then payouts may just as easily be cut, delayed, or even outright cancelled.

What is a dividend yield fund?

Instead of picking individual high-yielding stocks, investors can turn to dividend yield funds as an alternative. These types of investment funds are managed by experienced professionals and focus exclusively on delivering a consistent stream of income. 

Depending on the fund’s portfolio structure, it can be categorised two ways:

  • Dividend-yielding equity fund
  • Dividend-yielding debt fund

While debt funds are typically less prone to volatility, they often offer investors lower yields and slower long-term dividend growth.

How is dividend yield calculated?

To calculate the dividend yield of any stock, you take the total annualised dividends per share and divide it by the current share price.

However, finding the right total annualised dividends per share depends on the situation. 

Suppose a company’s fiscal year has recently ended, and the group has published its annual report. In that case, the correct figure can be found in the financial statements. 

It’s important to note that any special dividend payments should be excluded from the calculation. Why? Because these are one-time payments that will not be repeated in the future. Including them could inflate the dividend yield resulting in a misleading figure.

However, if a few quarters have passed since the publication of annual accounts, using the dividend per share from the report will likely be misleading. Why? Because several changes to a dividend policy may have occurred, such as a payout increase or decrease.

Suppose the group has recently announced a new quarterly dividend payment. In that case, a common technique is simply multiplying the dividend per share by four to calculate the annualised dividend per share. Similarly, if a stock pays a dividend twice a year, the announced figure should be multiplied by two to estimate the full-year payout.

This approach will return the forward dividend yield of a stock and can provide more accurate insight than using older dividend figures.

However, by multiplying a quarterly dividend by four, the investor is making the assumption that each dividend payment throughout the year will be equal. And for some companies, that is not the case. 

Therefore, investors should always look at historical dividend payments to determine the best approach for calculating the dividend yield.

What is a good dividend yield?

In theory, investing in stocks with the highest dividend yield seems like the best approach to building a substantial income portfolio. However, in practice, things are a bit more complicated.

The higher the yield, the more challenging it is for a company to maintain it. And in a lot of cases, it can be a strong signal to stay away. 

Don’t forget yield can be influenced by both dividends and share price. Any sudden downward movement in the stock can send the dividend yield surging. However, such volatility is usually triggered by a negative outlook on revenue, earnings, or cash flow. Any of one of these could lead to dividends being cut or suspended.

In fact, this is what happened with many travel stocks at the start of the 2020 pandemic. Seeing dividend yields as high as 20% was not uncommon following the stock market crash in March. Yet with the business models heavily disrupted, almost all companies cancelled shareholder payouts, leaving any investor lured in by double-digit yields bitterly disappointed.

So, at what level are dividend yields good?

The answer depends on the individual business. A yield can be considered good if the company’s underlying fundamentals can maintained it. 

A common metric used to judge yield quality is the dividend payout ratio. By comparing the total dividends per share to the earnings per share, investors can see how much profit is flowing out of the business to satisfy shareholders. A high payout ratio can be an early indicator of unsustainable dividends.

What is the average dividend yield on the FTSE 100? 

The FTSE 100 contains 100 different stocks whose dividend yields are constantly shifting. As such, the yield of the index is also in a state of flux. However, historically it has stood close to 4%.

YearAverage dividend yield

Why is dividend yield important?

The importance of the dividend yield ultimately depends on an individual investor’s financial goals. For retirees and other income-seeking investors, finding sustainable high-yielding dividend stocks is paramount for meeting living expenses.

Alternatively, the yield is less important to younger investors who are more interested in seeking higher risk and higher growth opportunities.

Advantages of dividend yields

The dividend yield is a useful metric to identify potentially lucrative income opportunities. While it’s not a definitive metric between good and bad investments, it often serves as a strong starting point when searching for high-quality dividend stocks.

The metric can also be used as a form of relative valuation. While less common, comparing the current dividend yield with its historical average can potentially signal a buying opportunity for the stock.

Once again, the yield alone is insufficient to determine whether a stock is over- or undervalued. But it’s a starting point for further investigation into a firm’s operations and cash flows.

Disadvantages of dividend yields

Even if a company has the cash flow necessary to maintain a high dividend yield, it may still not be a good long-term investment.

Dividends are a mechanism for returning excess capital to shareholders. However, for a company trying to maintain a track record, the management team may start using more than just leftover capital. In fact, there have been numerous cases of businesses taking on debt to maintain yields.

This results in fewer resources available for internal re-investment. And that can create opportunities for competitors to overtake a once-thriving enterprise through superior innovation.

How often is dividend yield paid?

The frequency of dividend payments for any stock is ultimately at the management team’s discretion. 

In most cases, dividends are paid every quarter. However, some companies prefer to execute payouts yearly, bi-annually, or even monthly. For the groups that only offer special dividends, the payments can occur at any time throughout the year.

It’s uncommon to see a company change the frequency or timing of dividend payments. Therefore, a quick glance at the historical payments of any income stock can help establish reasonable expectations.

RELATED: Top UK Monthly Dividend Stocks

How does dividend yield affect stock price?

Changes in a company’s dividend policy can significantly impact the share price, both positively and negatively.

Suppose a business has achieved sustainable growth in its earnings. In that case, the management team, in the pursuit of maintaining a constant payout ratio, announces an increase in the dividends per share.

With a larger payout being offered to shareholders, the yield increases. However, this increase also makes the shares more desirable to other income investors. This pushes the share price up and the yield back down. This also works in reverse. 

Suppose the same company later announces problems that compromise its earnings to the point where dividends are cut in half. In that case, the dividend yield is also is negatively impacted. This makes the stock less desirable to income investors and triggers a sell-off that sends the yield back up as the stock price falls.

This article contains general educational content only and does not take into account your personal financial situation. Before investing, your individual circumstances should be considered, and you may need to seek independent financial advice.  

To the best of our knowledge, all information in this article is accurate as of time of posting. In our educational articles, a "top share" is always defined by the largest market cap at the time of last update. On this page, neither the author nor The Motley Fool have chosen a "top share" by personal opinion.

As always, remember that when investing, the value of your investment may rise or fall, and your capital is at risk.