What is a Dividend Yield?
A dividend yield is the rate of return on your investment which is driven by dividend income paid out by company stocks which you might own. This is 1 of 2 possible sources of growing your wealth from stock investments – lets look at both of them first before continuing.
Stocks: 2 sources of wealth creation
1. Capital Growth: This is the buy-low sell-high part of stock returns, and pretty simple: if the price goes up / down, the value of your share capital goes up / down so you make a return / loss.
2. Dividends: some companies also pay dividends to their shareholders from the profits they generate. These dividends form a second potential way to earn a return from your shares.
Total % Return on Stock Investments = Capital Growth % + Dividend Yield %
Let’s talk dividends
When it comes to dividends, a company is not required to pay any (unlike, say, with interest on the debt it owes which is a legal obligation). That said, companies who pay dividends often have a track record of doing so, and company management often provide rough guidance in their earnings reports and press conferences as to whether or not they plan on continuing to pay the same level of dividends or not.
This is very important for investors because a company with a track record of paying dividends is reasonably expected to continue doing so – although this can often change in times of financial hardship. These dividend expectations mean investors are willing to pay a higher price to own shares of companies which pay dividends as they know that the dividend will offer an additional source of return aside from the usual capital growth.
When companies cut or remove their dividends, there is usually a large corresponding drop in the share price as the stock becomes less attractive for investors to own without the dividend return. There are numerous examples of this happening – you can read about AB-InBev’s 🍺 experience here. If the dividend cut is for good reason, however, the stock price tends to reflect that over the long run (check out AB InBev’s c. 30% share price increase in the 12 months after the dividend cut was announced!).
Now you know a little more about dividends, let’s look at dividend yields
A dividend yield is the dividend as a percentage of a company’s share price:
Dividend Yield = Dividend / Share Price
This is the generic formula for calculating dividend yield, but there are 2 main types we look at in practice: Trailing and Forward
This is the most recent dividends paid as a percentage of a company’s share price:
Trailing Dividend Yield = Most recent Dividend paid / Share Price
Trailing dividend yields are a helpful indicator of the dividend return you would be likely to earn if you purchased a company’s shares today and the company continued to pay the same dividends as it has been paying recently. The most recent dividend paid is a known, factual, number.
The trailing dividend yield gives you a good idea of what the company has been paying but as the saying goes, “past performance doesn’t always indicate future results”. This is where forward dividend yields come in.
Forward Dividend Yield
This is what analysts and investors think the next dividend will be as a percentage of a company’s share price:
Forward Dividend Yield = Expected amount of next Dividend / Share Price
Looking at the average expected forward dividend yield gives you a good sense what the market as a whole is expecting from the company.
As an example, the company might have gone into financial hardship after its most recent dividend and so may look unlikely to be able to continue paying dividends. The trailing dividend yield would look good but comparing it forward dividend yield might give you a hint that something isn’t quite right.
Forward dividend yields have their own drawbacks however, as these estimates of the future might not be accurate – different people have different opinions on what the future will hold after all, and expectations aren’t always right.
In practice it’s good to look at both trailing and forward dividend yield, but that’s not all. It’s also helpful to have a good understanding of whether the company is likely ability to continue paying dividends or if there might be any potential changes to future dividends.
Looking at dividend yields + having a good understanding of the company overall will help give you the best idea of what kind of dividend return you might expect in future!
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