What it means
An investor who buys a share receives two kinds of return: the dividends paid while they hold it, and the change in its price when they sell. The dividend yield measures the first, at the moment of purchase, as a rate of return on the price paid.
It allows shares to be compared with each other and with other income-producing assets: a share yielding 4% pays the same current income as a bond yielding 4%, though the share's income may grow and its capital may rise or fall, while the bond's income is fixed and its capital is repaid at par. The comparison between the equity market's average yield and government bond yields is a long-standing indicator of the relative attractiveness of shares and bonds.
The yield can be calculated on different dividends. The trailing yield uses the dividends actually paid over the last twelve months, which is factual but backward-looking.
The forward or prospective yield uses the dividend expected over the next twelve months, from the company's guidance or analysts' forecasts, which is what an investor will actually receive but depends on a forecast. Where a company has announced an increase, the two differ.
Yield on cost, the current dividend divided by the price the investor originally paid, measures the income return on the investor's own outlay and rises as the dividend grows, which is why long-term holders of growing companies can find themselves receiving 10% or more on their original investment while the market yield is 3%. The yield moves inversely with the price.
If a company holds its dividend and its share price halves, its yield doubles, which is why a very high yield is often a warning rather than an opportunity: the price has fallen because investors expect the dividend to be cut, and the yield calculated on the old dividend will not be received. This is the yield trap, and the defence against it is to check dividend cover, cash generation and the company's prospects before buying on yield.
A yield well above the sector's, with cover below 1.5 times and falling earnings, is usually a dividend about to be reduced. Conversely, a yield below the sector's may reflect a company whose dividend is growing fast, so that the yield on today's price will be much higher in a few years.
Yield and growth trade off. Total shareholder return, over the long run, is approximately the dividend yield plus the growth rate of the dividend (or of the share price, which tends to track it).
A share yielding 2% with dividends growing at 6% and a share yielding 6% with dividends growing at 2% offer the same 8% expected return, with different mixes of income now and income later, and different risks. Income investors prefer the first mix; growth investors the second; and the market's pricing of the two reflects its expectations about which growth rates will actually be delivered.
A high yield is compensation for low expected growth or high risk, not a free lunch. Tax and practicality complete the picture.
Dividends are taxed differently from capital gains in most systems, and the after-tax yield is what matters to the investor; some investors, such as pension funds, pay no tax on either, and some jurisdictions give credits for the corporate tax already paid. Dividends are also paid on fixed dates, and the price falls by about the dividend on the ex-dividend date, so the yield cannot be captured by buying just before it.
A yield is a rate of return on a long-term holding, and its usefulness lies in comparing the income that different investments will produce over years.
In practice
Real-world examples.
Example
A pension fund compares the equity market's 3.2% average yield with the 4.0% yield on government bonds and notes that shares must deliver dividend growth of at least 1% a year to match bonds, which it regards as very likely.
Example
An investor holding a consumer goods company bought at $20 twenty years ago now receives $2.40 a share in dividends, a 12% yield on cost, while the shares yield 2.5% at their current $96 price.
Example
A screening tool lists the ten highest-yielding shares in an index, and an analyst finds that six of them have dividend cover below 1.2 times and three have already announced reviews of their dividend policy.
Think of it
“Dividend yield is like the interest rate on a savings account, but for stocks. It shows how much cash income you get relative to what you invested.
Formula
Calculation
Dividend yield = Annual dividend per share / Share price x 100
Trailing yield uses dividends paid in the last twelve months; forward yield uses the dividend expected in the next twelve
Yield on cost = Current annual dividend per share / Price originally paid x 100
Approximate total return = Dividend yield + Expected growth in dividends
After-tax yield = Dividend yield x (1 minus Investor's tax rate on dividends)
Worked example. A company paid dividends totalling $0.48 a share over the last year and its shares trade at $24. It has announced that next year's dividend will be $0.52.
- Trailing yield = $0.48 / $24 = 2.0%
- Forward yield = $0.52 / $24 = 2.17%
- An investor who bought ten years ago at $12 has a yield on cost of $0.48 / $12 = 4.0%
- If dividends are expected to grow at 6% a year, the approximate total return is 2% + 6% = 8%
- For an investor taxed at 30% on dividends, the after-tax yield is 2.0% x 0.70 = 1.4%
Yield trap illustration. A competitor's shares have fallen from $40 to $16 over a year while its dividend has been held at $1.20, so its trailing yield has risen from 3% to 7.5%. Its earnings per share have fallen to $1.05, so cover is 0.88 times, and its free cash flow does not cover the dividend at all. The 7.5% yield is the market's expectation of a cut; if the dividend is halved to $0.60, the yield on the $16 price is 3.75%, and an investor who bought for the 7.5% will receive half of it and probably suffer a further price fall.
Comparison with bonds. If ten-year government bonds yield 4%, a share yielding 2% with 6% expected dividend growth offers a higher expected total return but with more risk and more of its return deferred; a share yielding 5% with 1% growth offers a similar total return to the 2% share with more income now.Case study
Seen in the real world.
A retired investor with $500,000 to invest for income built a portfolio of the ten highest-yielding shares in the market, on the reasoning that yield was income and more was better. The portfolio's average yield was 8.2%, promising $41,000 a year against the $20,000 that a bond portfolio would have paid. The largest holding, $100,000 in a retailer yielding 9%, was expected to contribute $9,000.
Within eighteen months, four of the ten companies had cut their dividends and two had suspended them. The retailer, whose yield had been high because its share price had already fallen 40% on weak trading, cut its dividend by 60%: the $9,000 became $3,600, and the shares fell a further 40% to $60,000.
Across the portfolio, income for the second year was $23,000, barely more than the bonds would have paid, and the capital had fallen to $380,000. The investor's adviser, consulted late, explained that the portfolio had been constructed from the shares the market most expected to cut their dividends, because a high yield on a fallen price is precisely that expectation.
The rebuilt portfolio applied three filters before yield: dividend cover of at least 1.5 times on underlying earnings, free cash flow covering the dividend, and a record of maintaining or growing the dividend over the last ten years including the last downturn. The shares that passed yielded an average of 4.1%, half the original figure, but the dividends were sustainable and growing at about 4% a year.
After five years the portfolio's income had grown to about $25,000 on the original capital and the capital had recovered. The investor's conclusion was that a dividend yield is a promise the market is pricing, and that the price of an 8% yield had been the market's judgement that the promise would not be kept.
Watch out
Common mistakes.
- Buying shares on yield alone, without checking cover and cash generation; the highest yields are usually the dividends the market expects to be cut.
- Comparing a trailing yield calculated on last year's dividend with a forward yield on next year's, or comparing yields on different tax bases, without adjusting.
- Trying to capture a dividend by buying just before the ex-dividend date, when the price falls by about the dividend on that date and the tax on the dividend may make the trade a loss.
Questions
People also ask.
What is the difference between dividend yield and earnings yield?
Dividend yield is the dividend per share divided by the price; earnings yield is earnings per share divided by the price (the inverse of the price-to-earnings ratio). The dividend yield is the earnings yield multiplied by the payout ratio.
Is a high dividend yield good?
Only if the dividend is sustainable. A high yield on a company with strong cover and stable earnings is attractive income; a high yield on a company whose price has fallen because its dividend is at risk is a trap. Cover, cash flow and the dividend record distinguish the two.
Why do growth companies have low yields?
Because they retain their earnings to fund investment that earns more than shareholders could elsewhere, and because their share prices reflect expected growth, which makes the current dividend a small percentage of the price. Their return comes through price appreciation and, later, a growing dividend.
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