If investing is something you’re considering, dividend yield is a concept you must understand because it applies to stocks, mutual funds, and ETFs. That’s why we present a simple and totally non-technical explanation.
What is dividend yield?
Companies pay out dividends to their shareholders. The dividends invariably go out of the company’s profits during the year.
The dividend yield is a metric that shows how much an investor would earn from dividend payments. It is the ratio of the income earned in dividend payouts per year relative to its stock price. The yield applies to payouts from stocks, mutual funds, or Exchange-Traded Funds (ETFs). It is the dividend received divided by the market price of a stock as a percentage.
Understanding the concept better in relation to stocks
This metric is quite important when the objective is to generate investment income. However, it cannot be the deciding factor when considering an investment. Just because the numbers are impressive now, it does not mean they will continue to be so. The company may choose to change its dividend payout strategy. Increased dividend payout can also mean the company has less profit to return to the business. The business could miss out on future profits by not cashing in on growth opportunities.
Furthermore, needless to say, this metric only applies to dividend-paying companies.
The calculation is quite simple. Just divide the dividend payout by the market price and multiply by 100.
So, suppose ABC Company Ltd. has paid a dividend of ₹20 per share. And the current market price of the share is ₹400.
The dividend yield, in this case, is: 20/400 X 100 = 5%
Please note that there is no guarantee that future yields will remain unchanged. The dividend could be different, just as the market price could vary. So, prudent investors do not base their investment decisions on this metric alone.
The pros and cons of dividend yield
Let us now look at the pros and cons of the concept. We can begin with the pros:
1. The metric refers to a source of income. So investors looking for a steady flow of income—like retired people—could look for companies that yield dividends.
2. The metric is useful when it comes to demonstrating the stability of a company. When the company has a history of consistent earnings, there is less volatility. That means the portfolio is more stable as the market price doesn’t fluctuate heavily.
The cons of relying on this metric are as follows:
1. A high dividend yield implies a greater payout from a company’s profits. While this might seem great initially, it leaves the company a lesser corpus for reinvesting. As a result, the scope of business growth is limited.
2. Companies can always choose to restrict or stop their dividend payments. When this happens, it can adversely affect the market price of shares and eat into the investor’s income.
3. While the dividend yield is an important metric, one must not lose sight of other factors like the company’s overall health, future prospects, and industry trends because some companies resort to a higher dividend to ensure investor confidence. In such cases, a high dividend yield can mislead the investor.
Dividend yield vs. dividend payout ratio
We have seen that dividend yield is the dividend received divided by the current market price multiplied by 100 and represented as a percentage value. The dividend paid is the amount of dividend in rupees paid on the face value of the share.
Companies invariably do not pay out all the profits earned as dividends. The earnings per share (EPS) is calculated by dividing the company’s total profits by its total number of shares.
The dividend payout ratio refers to the ratio of dividends paid divided by the EPS.
So, going back to the example of ABC Company Ltd., the company has an EPS of ₹10 and pays a dividend of ₹4 to its shareholders. So the payout ratio will be 40%.
In the same example, if the current market price of these shares is ₹40, the dividend yield will be 4/40 X 100 = 10%.
Both these metrics have inherent limitations, as we have seen earlier, and you must view them in isolation when making an investment decision.
Is a high dividend yield always best?
No, not always. You need to look at various other factors—like the company’s financial health, market condition, growth prospects, etc.—while evaluating the significance of the dividend yield. Because a high dividend yield can sometimes starve the expansion plan, impacting its future profits and marking a decline in the market price of shares.
Besides, there is no guarantee that the company will sustain a high dividend yield in the future.
Conversely, a comparatively low dividend yield company could be reinvesting its profits. As a result, it may benefit from industry trends and yield higher dividends in the future.
The dividend yield is an important metric but cannot be the only deciding factor. A consistent dividend yield across the years is sometimes an indicator of a company’s stability. But it cannot guarantee that it will always be the same.