How To Calculate Dividend Yield and Why It Matters

Dividends are distributions from companies to shareholders. Although some companies pay dividends in shares of their stock, traditional dividends are distributed in cash, often quarterly. For some shareholders, a high dividend yield is the main reason they invest in a stock.

See: 3 Things You Must Do When Your Savings Reach $50,000

Understanding the true value of the top dividend-paying stocks, however, goes beyond calculating their dividend yield. Here’s a look at what you need to know about dividends, how to calculate a dividend yield and what it means in terms of building wealth.

Understanding Dividends

A dividend is defined as the distribution of corporate profits to a company’s qualified shareholders. Dividends are decided by the company’s board of directors and must be approved by shareholders. Some ETFs and mutual funds also pay dividends.

It’s important to understand that dividends aren’t mandatory — rather, they can be seen as rewards that incentivize shareholders to continue investing in the company. Although it’s up to the company’s board of directors to determine how and when a dividend is paid, the most common method is through quarterly dividend payments.

What Is a Dividend Rate?

A company’s dividend rate is the amount of its payout. For example, if Apple pays $0.63 per share in dividends every quarter, its annual dividend rate is $2.52, or four times $0.63. But when it comes to dividend yield, the dividend rate is only half of the story.

Calculating Dividend Yield

The dividend yield is the ratio between a company’s dividend payout and its stock price. Because stock prices change with every trade on the market, the dividend yield is also constantly changing.

To calculate a stock’s dividend yield, take the company’s total expected payout over the course of a year and divide that by the current stock price. The mathematical formula is as follows:

Dividend Yield Examples

Because the dividend yield is a ratio, the same dividend rate can mean different yields for different companies.

For example, imagine two companies, each paying a $1 annual dividend rate. The first company trades at $40 per share, whereas the next company trades at $20 per share. Calculate the yields on these companies by using the dividend yield formula:

Dividend Yield of Company No. 1 = $1 / $40 = 2.5%

Dividend Yield of Company No. 2 = $1 / $20 = 5.0%

If your main goal is to get the most out of your dividends, Company No. 2 is likely the better buy. That said, a higher dividend yield isn’t always better. Take a look at the company’s history and recent stock activity.

That high dividend yield might not be consistent — it might also mean the stock price recently took a hit. If the price per share recently dropped and the annual dividend hasn’t been adjusted yet, the dividend yield might look high but may be unlikely to stay that way.

What Is a Good Dividend Yield?

Anywhere between 2% and 6% can be considered a good dividend yield. A typical S&P 500 dividend yield in 2023 is between 1.61% and 2.09% — so a yield over 2% could be considered above average.

Is a High Dividend Yield Always Better?

However, a dividend yield higher than 6% might spell trouble. High dividend yields are often unsustainable and might indicate that the company is overpaying in dividends rather than investing in its bottom line.

That doesn’t mean a high dividend yield is always a bad sign. There are some safe dividend stocks that consistently offer yields over 7% or even 8%. But generally speaking, the higher the yield, the riskier the stock.

Other Factors To Consider

Understanding a stock’s dividend yield can help you evaluate your potential ROI. However, when it comes to getting the most out of dividends, the dividend yield isn’t the only ratio you’ll want to pay attention to. You should also look into each company’s dividend payout ratio and dividend coverage ratio.

Dividend Payout Ratio

A company’s dividend payout ratio measures the proportion of its earnings that it pays out as dividends. This ratio is calculated by dividing total dividends by the company’s net income.

A high DPR is not necessarily a dangerous thing. Many of the highest dividend-paying stocks are companies with predictable revenue streams that pay out a high proportion of those earnings as dividends to entice investors.

For other companies, however, a high ratio can portend trouble. If a company’s cash flow dips, it might not be able to sustain its dividend payout, resulting in a dividend cut.

Dividend Coverage Ratio

The dividend coverage ratio shows the number of times a company or security can pay dividends. You can calculate a company’s DCR by dividing its net income by its declared dividend.

A higher DCR is generally considered more favorable. For example, a DCR of 2-1 shows that a company can afford to pay its declared dividends twice annually, while a DCR of 1.5-1 or lower could mean financial trouble.

When Are You Entitled to Dividends?

To be entitled to a dividend, you must be in the company’s books as a shareholder by the record date.

Check the dividend calendar for the stock you’re interested in. You must own the shares before the ex-dividend date, which is when the stock trades without the dividend until the next quarter. This is generally one business day before the record date.

If you buy the stock on or after the ex-dividend date, the upcoming dividend goes to the seller.

Importance of Dividend Yields

Dividends provide peace of mind for some investors, because the volatility of the stock market can be unsettling. The top dividend stocks provide investors with cash returns every year, regardless of the company’s stock price performance. Dividends also provide a hedge against inflation, because the dividends of reliable companies tend to increase over time.

Dividends can also help pay back the original investment over time. For example, if you buy a share for $40 and that company pays a $1.20 dividend every year, you’ll get your entire investment back in about 33 years. If that dividend grows 5% yearly, you’ll be made whole in just 20 years, even if the stock price goes to zero.

FAQ

Here are the answers to some common questions about dividend yields.

• Is a 7% dividend yield good?

  • A 7% dividend yield is high, which seems good at first glance – and if that dividend comes from a company with strong fundamentals and a history of paying its dividends, that might be true.

  • However, a high dividend yield can also be a sign that the company is paying too much in dividends, which it might not be able to sustain.

• How much is a 4% dividend yield?

  • The amount that a 4% dividend yield will translate to in dollars depends on the price of the stock. Multiplying the dividend yield by the market share price will give you the dollar amount of a 4% dividend yield.

• How much in dividends would you need to make $1,000 a month?

  • To make $1,000 a month in dividends, your combined investments would need to offer $12,000 in dividends per year.

Quinlan Grim contributed to the reporting for this article.

This article originally appeared on GOBankingRates.com: How To Calculate Dividend Yield and Why It Matters