What is a dividend yield?

A dividend yield is a chunk of the company's profits that gets paid out to shareholders. Each year, the directors have to decide how much of each year's profits (assuming they make any), will be paid out to shareholders in the form of a dividend, usually in two installments, and how much will be retained to grow 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).

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%).

Dividend yield: companies don’t have to pay dividends

It’s important to understand that companies don't have to pay dividends. And just because they paid one this year, doesn't mean they have to do it next year. A company may vary its dividend according to how profitable the past year has been; whether it needs to hold on to more of its profits to invest in maintaining or growing its business; or whether it has more cash than it needs and wants to make an extra one-off payment to shareholders (often called a special dividend). So we need to take this into account.

To get a more complete picture, 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 yield: red flags to look out for

A firm with a very high yield may look cheap, but this could indicate that investors expect the dividend to be cut. In other words, sometimes the yield is high only because no one believes it will actually be paid. Meanwhile, a firm trading on a low current yield might still be attractive if the dividend is expected to grow rapidly in the years ahead. 

It’s true that generally speaking, companies would rather not cut their dividends. A dividend cut is almost always a very obvious sign that something has gone wrong, and it often results in board members falling on their swords (or being pushed). But it can and does happen. 

So 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. 

Dividend cover and payout ratios

There are several ways to sense-check dividend sustainability. You can look at “dividend cover” or “payout ratios”. Dividend cover measures the number of times greater the net profits available for distribution are than the dividend payout. You calculate it by dividing earnings by the total dividend payout, or alternatively, you can divide earnings per share by dividend per share – either will give you the same answer. 

A firm that makes £10m in profit and allocates £1m for dividends has a cover of ten and a firm that makes £25m but pays out £12.5m in dividends has a cover of just two. 

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.

There are several other ways to sense-check dividend sustainability. For more on the topic, subscribe to MoneyWeek magazine.