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In this FAQ video we’re going to explain:
0:20 - What is dividend yield
0:29 - The dividend yield formula
2:58 - How to spot the best dividend stocks
3:33 - dividend payout ratio
Dividend Yield 101
Dividend yield is a metric all dividend investors obsess over, it refers to a stock's annual dividend payments to shareholders, expressed as a percentage of the stock's current price. Here’s the actual formula.
For example, as of taping, Microsoft shares cost around $167 and the company pays a quarterly dividend of 51 cents. If the dividend stays exactly the same, over 12 months, investors will receive 4 dividend payments, totaling 2 dollars and 4 cents.
Dividing that payment total by the current share price, you get a yield of around 1.2%
Now, it's important to realize that a stock's dividend yield can change over time, either in response to market fluctuations or as a result of dividend increases or decreases by the company.
That’s why it’s important to understand the underlying equation for calculating yield, and why it’s important to consider yield and total return.
Dividends are just one component of how investors can make money, you should also look at total return.
This takes dividend yield and includes the increases (or decreases) in share price too.
For example, if a stock's price goes up by 5% this year and it pays a 3% dividend yield, then your total return is 8%.
A stock’s dividend yield can go up dramatically because a company’s share price falls.
Say a shares of a stock go from $20 to $10 over the course of a year, and its dividend of $1 stays exactly the same. The company’s yield would go from 5% to 10%, and seem like an awesome opportunity for investors that haven’t been following the company closely.
That’s why in addition to looking at yield, you should look at the company overall, here’s a quick list of things to keep in mind:
Do you understand the business? -- Can you explain what they do and how they make money? If you can, you’ll be able to recognize and understand how the business is doing financially.
Is the company growing? -- Is the company posting revenue growth, and is that growth generally in line with where it has been in the past? A growing business is more likely to be a healthy business.
Is the business relevant in its industry? -- This is harder to measure, but the idea is that you generally want to own market leading companies, or companies poised to become market leaders. If an old business is in the process of being disrupted, it probably doesn’t make for a great dividend stock
One way to take a lot of these factors into a digestible metric is to look at the company’s payout ratio. This measures how much a business pays in dividends relative to its net income.
The reason we look at this is that dividend payments are something a company elects to do, and if they’re struggling they might decide to cut their dividends.
There isn’t a single “right” figure for the payout ratio, but the idea is that you want it to look at the number relative to where it has been in the past for the company and how the company compares to its peers.
If the ratio suddenly spikes up unexpectedly, that could be a sign that the company might have trouble maintaining its payments down the road unless it is able to bring in more money with its operations. And if a stock’s payout ratio is over 100%, it means that the company is paying out more in dividends than it is making in income, which isn’t sustainable long-term.
One last thing on dividend yields -- there are special structure businesses like real estate investment trusts and master limited partnerships that operate differently than your standard business -- they have higher yields because they are built to share more of their income with their shareholders. There are great REIT and MLP investments out there, but they require using industry-specific metrics to evaluate, we’ll drop the link to our REIT video in the comments section.
Point is, investors looking only at yield might accidentally buy MLPs and REITs without realizing it, and that could open them up to complex businesses and complicated tax structures -- that’s why item number one on our checklist before was, do you understand the business. Make sure you do your homework first and don’t just scoop up shares of high yield stocks.
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