Another key ratio used by value investors, as well as by those seeking positive cash flow, is the dividend yield.
Whereas value investors seek companies with relatively low price-to-earnings (P/E) and price-to-book (P/B) ratios, they desire companies with high dividend yields. Lower risk investors like high dividend payers for both the cash flow it generates and the the quicker payback on their invested capital.
What is Dividend Yield?
There are two ways to think about dividend yield.
First, dividend yield is an indicator of how much annual cash flow an investment generates.
If you own an investment that yields 10% per annum, you know how much cash flow you will receive each year. If you invest $100, you will receive $10 each year.
Some investors may need a specific cash flow to fund their lifestyle. Retirees are a good example. Knowing with some certainty what the annual cash payout will be, as opposed to hoping the share price increases, is very useful.
Additionally, when comparing potential investments, understanding the relative cash flow may help determine what to purchase. If the average industry dividend yield is 8% and you identify a company yielding 12%, that may be a nice value investment. Of course, offering a higher than “normal” dividend might also foreshadow future difficulties too.
Second, the dividend yield indicates the payback period on an investment.
That is, how much time is required for repayment of your initial capital. If you invest $1000 in a company with a 10% annual dividend, you will recover your original $1000 in 10 years.
A good analytical tool if you are concerned about the safety of the capital you initially invested.
That said, I would be more concerned about payback period if I was drilling an oil well, buying commercial real estate, or expanding manufacturing facilities as opposed to investing in a stock. But there are some investors who are interested in payback periods via dividends.
Calculating the Dividend Yield
Dividend yield is calculated by taking the amount of dividends paid annually divided by the current share price. Or the price you paid when investing.
Unless the dividend is increased or decreased by the company, the yield will be constant for existing shareholders.
For example, ABC company pays a steady $1 per year dividend. You bought 100 shares at $12 per share. Your sister bought 200 shares at $8 per share and your brother bought 500 shares at $15 per share.
You will receive $100 in dividends annually with a yield of 8.3%. Your sister will receive $200 annually. But because she bought at a lower share price, her dividend yield is 12.5%. And your brother will receive $500 in dividends each year. However, as he bought his shares at $15 each, his dividend yield is only 6.7%.
Some companies may pay dividends in terms of percentage payouts. Do not confuse this with the yield. The dividend yield is based on the price you paid for the shares. The stated percentage dividend is based on the share’s par value at issue.
For example, Fixedco issues A Class Preferred Shares at $100 par value with a fixed 6% annual dividend. For each share you own, you receive 6% of the par value. In this example, $6.
If you purchased the shares at $150 each, you will still receive 6% of the par value, not 6% of your purchase price. You will earn $6 annually and your dividend yield will be 4%.
You may also see bonds that are variable rate or reset based on certain conditions. For example, the 6% fixed rate may be adjusted for inflation every 2 years.
Dividend Yield and Share Price
Assuming a fixed dollar or fixed percentage dividend, investors’ yields will vary dependent on when they purchase the shares. Fixed rate dividends are usually seen in preferred shares.
If investors paid more than the par or issued value for the shares, their yields will be lower than the original fixed yield.
If they paid less than par or issue value, they will receive a higher yield.
We saw this in the examples above. As well, exactly the same principle as with bond yields.
If the dividend paid varies over time, as is the case of most dividend paying common shares, then a shareholder’s dividend yield will also vary. Many companies increase their dividend payouts in good times. In bad periods, some companies will reduce issued dividends. Though, due to the perceived negative message sent to shareholders and potential investors, companies usually try to avoid decreasing payouts.
Given that the cash value of dividends paid out over time may change, as well as the share price will fluctuate, it is usually a good idea to track two yield calculations.
One, the yield based on what you paid for your shares. Two, the yield based on current market value.
For example, you purchase 100 shares at $10 per share. The annual dividend is $1 per share. Your dividend yield is 10%.
A year later, the company increases its dividend to $2 per share. Based on your purchase cost, your yield is now 20%. However, investors are extremely bullish on the stock and the share price has grown to $25. The current yield on the shares is now only 8%. If you purchased another 100 shares at the current price, now your new adjusted cost base will be $17.50 per share. Your new overall dividend yield will be 11.4%.
Analytical Considerations
As with price-to-earnings, investors consider dividend yields based on actual payouts (e.g. previous year, 5 year average, etc.) and on on expected future payouts.
If assessing whether to invest in shares, I suggest comparing the expected future yield against the 5 year average payout to determine any trend of increasing or decreasing the dividend.
I remove any extraordinary or special dividends from my comparative data.
These dividends are paid only on special occasions and are not recurring in nature. Excluding them from the analysis allows for better comparison with normal dividend payments.
I also review the company’s dividend history.
Have prior year dividends been stable or increasing in amount? Or have there been periods when dividends were reduced or not paid? If the former, there is more comfort that future dividend streams will continue. If the latter, the risk of reduced future income rises.
Finally, or perhaps firstly, consider the after-tax ramifications of dividend payouts. Tax laws differ between jurisdictions, but always focus on your net cash flow. Not gross payouts.
For example, in Canada, certain dividends are eligible for tax credits. This increases the net yield versus dividends received from a non-eligible issuer. Or perhaps a foreign issuer withholds tax when paying out dividends. This may or may not be recoverable, but is always worth considering.
Next week we will look a little more deeply as to why dividend yield knowledge is important for investors. We will also review the potential limitations when using dividend yields in your investment analysis.
