What is a dividend yield?

A dividend yield tells us what percentage of a company’s current share price is paid out in dividends each year.

A company usually pays a dividend as a way of returning excess profits to investors. It can also be described as a reward or thank you to shareholders for taking on the risk of investing in the stock in the first place.

What is a dividend?

The main aim of any business is to make a profit, otherwise, it’s not a productive use of capital.

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Profits are used to pay staff, 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.

Each year a business’ managers, or in the case of a public company, its directors, will sit down to decide whether they should pay a dividend, and if so, how much they should return to shareholders and how much they should hold back in the business.

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).

What is a dividend yield?

The return from dividends on any given stock or share index is measured by the dividend yield. This is the latest annual dividend, divided by the current share price as a percentage.

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.

How to calculate a historic dividend yield

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 are unreliable. Investors should 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 no one believes it will actually be paid. 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 reports EPS of 20p and pays a dividend of 10p per share, its cover is two. That’s a healthy level.

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.