Choosing the best stocks to purchase and companies to invest in is a gruelling process. If you’re focused on building a stream of passive income, the dividend yield is an important metric you should factor in your analysis process. But what is the dividend yield, why is it so important, and how do you calculate it?
What is the dividend yield?
The dividend yield is usually expressed as a percentage and is essentially the ratio of the dividend divided into the current stock price. This calculation showcases how much a company pays out in dividends to shareholders per annum relative to its stock price.
This metric only covers the dividend yield and not any earnings or losses for the shares themselves. Since the yield is based entirely on the yearly dividend payout and the current stock price, the dividend yield can fluctuate depending on market conditions.
Should the stock price increase considerably, the dividend yield will decrease unless the company boosts its dividend payout. It’s inversed should the stock price fall. This is why it’s sometimes handy to work out the yield on cost, as well as the yield on current stock price to see how your portfolio is performing.
Usually, you’d find mature companies with steady, low growth sporting higher dividend yields than newer companies that are rapidly rising in the market.
How to calculate the dividend yield
Working out the dividend yield is straightforward. You simply divide the annual dividend payout into the current stock price (or the price you paid for your shares).
Annual dividend per share ÷ Share price = Dividend yield
Not all companies pay annual dividends, which is where inaccuracies can come into play. A stock like Realty Income (O) pays out a dividend on a monthly basis. In order to work out and track an up-to-date, accurate dividend yield, you could multiply the most recently declared dividend payout by 12 to get the annual dividend and then divide it by the share price.
My special dividend tracker does just this. The spreadsheet asks for the last declared dividend, how often the dividend is paid, and then calculates everything automatically. But the dividend yield isn’t always the most useful metric to use for investing, which leads me onto my next point.
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High dividend yield isn’t always best
Higher dividend yields mean you get more in return for holding shares of a company, right? Wrong! If the share price of the company you hold shares in plummets due to weak earnings and they manage to keep the dividend payout the same, the dividend yield will skyrocket.
A company will try not to cut the dividend payments to keep hold of as much investor funding as possible. But a super-high dividend yield with weaker earnings may be difficult to maintain, which can cause further issues for the company down the line. This isn’t good for the executive team, investors, or company staff.
The sweet spot I like to have dividend yields at is between 2% and 5%. If you can safely hold various positions at the upper end of that range, you should be sailing above inflation and the usual interest rates for savings accounts.