What is a dividend yield?
Dividend yields are a key metric that tell income-focused investors how much they’ll earn for their investment in a stock.
For all investors, particularly those focused on earning income from the stocks they hold, understanding dividend yield is crucial.
A dividend yield tells us what percentage of a company’s current share price is paid out in dividends each year.
Companies pay dividends to their shareholders as a means of rewarding them for investing in their business. They are, theoretically, the key mechanism through which investors get paid back for buying stocks and investment trusts.
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You can get back more than you paid for a stock if its share price rises and you sell at a profit – but ultimately, that will be because the buyer expects the company to pay a higher dividend in future.
“If anything, history suggests that it is dividend growth that is the real secret sauce for a share price, as a growing pay-out has the potential to drag it higher over time,” said Russ Mould, investment director at investment platform AJ Bell.
Dividend yields are important to understand because they relate the dividend you are paid to the price you pay for the stock.
Imagine you are considering investing £1,000 into one of two different stocks: Stock A or Stock B. Stock A pays a dividend of 10p per share. Stock B pays a dividend of 30p per share. Which is the better investment?
While it’s tempting to say Stock B, you can’t answer the question without knowing how much each costs.
If Stock B costs £10 per share, but Stock A costs £2 per share, your £1,000 investment will buy you £50 of annual dividends if invested in Stock A, but only £30 of annual dividends if invested in Stock B.
In this example, Stock A has a higher dividend yield (5%) than Stock B (3%).
So rather than looking at the absolute amount that companies pay in dividends, it’s more informative to assess dividend yield: the percentage of a company’s share price each shareholder receives as a dividend.
What is a dividend?
The main aim of any business is to make a profit, otherwise, it’s not a productive use of capital.
Profits invest in growth, strengthen the balance sheet for a rainy day and reward the investors who backed the business in the first place.
A company might choose to reward its investors with a dividend, assuming it’s generating enough cash to cover all its other operating expenses and spending obligations.
For example, if profits (after tax) are £100,000 and £50,000 is paid out as a cash dividend, then only £50,000 can be kept back by the directors for growth. That's why (traditionally at least) some firms grow fast, but pay low dividends (technology firms are typical) while others offer high dividends but lower growth prospects (utilities often fit this description).
Certain sectors or indices, such as the FTSE 100, are known for paying high dividends.
What is a dividend yield?
The return from dividends on any given stock or share index is measured by the dividend yield. It is calculated as follows:
Full-year dividend per share payment ÷ share price
That number is then multiplied by 100 to give the percentage figure representing the dividend yield.
For example, if a company paid a single dividend of 10p per share this year and its shares are trading at a price of 1,000p, the dividend yield would be 10p ÷ 1,000p = 0.01 (which is 1%).
If the firm paid a dividend of 5p after half a year (usually called an interim dividend) and a further 10p at the end of the financial year (a final dividend), you would add the two together and get (5p + 10p) ÷ 1,000p = 0.015 = 1.5%.
Companies don’t have to pay dividends
It’s important to understand that companies don't have to pay dividends. After all, dividends are a return of profit. If a business isn’t making any money, it shouldn’t be giving money back to its shareholders.
Some public companies try to pay what’s known as a “progressive dividend.” This means they try to keep the dividend growing year after year. These are usually defensive businesses, such as utility companies, which have predictable revenue streams.
However, other equities might choose to pay a smaller regular dividend, and then present shareholders with large, one-off special dividends when profits are better than expected. This is quite common in the resource sector, where commodity prices (and as a result, profits) can be very volatile.
There are lots of factors that determine whether or not a company will pay a dividend to its shareholders. And just because they paid one this year, doesn't mean they have to do it next year.
There are good reasons why even very profitable companies might not pay a dividend. The more they pay back to shareholders, the less they can invest for future growth. Often, companies decide that shareholders’ long term interests are best-served by reinvesting back into the business and generating higher profits in future.
In fact, some investors (particularly growth-focused ones) look sideways at companies with high dividend yields, viewing it as a sign that the company has exhausted all its potential for growth and can’t do anything more useful with the capital they are generating.
Can you only calculate historical dividend yields?
To get a more complete picture of a firm’s dividend the dividend yield can be calculated based on what the firm paid in the past 12 months or calendar year (sometimes referred to as the trailing or historical dividend yield) or on the amount that it’s expected to pay over the next 12 months (a forecast or forward dividend yield).
Trailing yields reflect what has actually been paid – but past dividends may not be sustainable.
Forecast yields reflect any changes that analysts expect, but forecasts can be unreliable.
“Markets are forward-looking mechanisms and as such investors should focus on forecast, or prospective, dividend figures,” said Mould.
It pays to look at both, but should not rely solely on either to make their decision: you need to think about the long-term prospects for a firm’s dividends, including any signals that the market is sending.
Dividend red flags
A good way to determine whether or not a company can maintain its dividend is to look for some common red flags. These may indicate an imminent dividend cut.
For example, a firm with a very high yield may look cheap, but this could indicate that the market doesn’t think the company will be able to afford to maintain its current level of dividends. This is a common red flag.
Another red flag is high debt levels. If a company has a lot of debt, these obligations will fall due at some point. From a business point of view, paying off creditors must be done before and return of profits to shareholders is considered.
It's important to safety-check the dividend, to test just how sustainable it is – especially if the dividend yield looks particularly large compared to the rest of the sector.
Using dividend cover to check the dividend yield
There are several ways to sense-check dividend yield sustainability.
One way is to look at “dividend cover” or “payout ratios”.
Dividend cover measures the number of times profits cover the payout. The earnings per share (EPS) figure is usually used in this calculation.
EPS measures total net profits divided by the total number of shares outstanding for a public company. If the business is expected to report EPS of 20p over the next year and pays a dividend of 10p per share, its cover is two. That’s a healthy level.
“A ratio under 1.0 suggests danger,” said Mould, excepting real estate investment trusts which are obliged to pay out 90% of earnings, “or if the company offers fabulous free cash flow and a strong balance sheet”.
While cover usually differs across sectors, theoretically the higher the figure, the more secure the dividend.
A dividend that is well covered typically signals that a company has sufficient capital to pay out dividends. But this does not necessarily mean the company can actually afford to pay the dividend, let alone actually will.
Using cash flow to check the dividend yield
You can also look at cash flow to check the sustainability of a company’s dividend payouts.
“In dividend investing, you want to be focused more on cash flow than earnings, because dividends get paid out of cash flow, not earnings,” said Sam Witherow, portfolio manager of JPMorgan Global Growth & Income.
Witherow recommends comparing free cash flow to earnings. Ideally, free cash flow should be approximately the same as or higher than earnings, but if it is below, it is worth looking at whether the gap between them is narrowing or widening. If it is widening, this could be a sign that current dividend levels are unsustainable.
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Dan is a financial journalist who, prior to joining MoneyWeek, spent five years writing for OPTO, an investment magazine focused on growth and technology stocks, ETFs and thematic investing.
Before becoming a writer, Dan spent six years working in talent acquisition in the tech sector, including for credit scoring start-up ClearScore where he first developed an interest in personal finance.
Dan studied Social Anthropology and Management at Sidney Sussex College and the Judge Business School, Cambridge University. Outside finance, he also enjoys travel writing, and has edited two published travel books.