The Dividend Yield explained.

The dividend yield (DY) is a financial ratio that measures the amount of cash that is paid out as a distribution to shareholders relative to the market value per share. A company earns profits, as shareholders we are entitled to a share of profits, and the dividend is our slice of that profit.

The dividend yield is the annual return an investor expects on their capital on top of any capital growth. If the dividend remains stable, the yield often rises if a stock price is falling as the return becomes greater for every share owned. If the yield becomes lower it is often because the share price is rising all things being equal.

Some investors especially retirees have a lot more emphasis towards income, and dividends help provide passive cash flow to them. Dividends make up a very large part of total returns on the stock market especially if they are reinvested and compounded over time. Income-focused investors will usually pick companies that have a strong balance sheet and that has consistently paid out dividends so that it can be a reliable source of income.

Other investors that are focusing on income may be those building the passive income component of their portfolio. A lot of the FIRE movement is focused on dividends as they can meet the required draw-down rates to live off while preserving the capital.

For me, I am more focused on growth companies as I want them to retain earnings to fuel growth not pay out profits. Investors focused on long-term growth will closely monitor the payout ratio to ensure the company retains earnings. Depending on where you are geographically, Dividends are taxed differently. In Australia, they can be fully franked dividends (Shareholders are entitled to a franking tax offset for the tax the company has paid on its income) so shareholders don’t “double up” on paying tax. In places like the USA, shareholders pay the tax component.

If you are not focused on income, then it is better to have the company compound that capital in a more tax-efficient manner than to pay out earnings to its shareholders.

High dividend yields while they can seem attractive are usually not sustainable. It can come at the expense of the business investing in growth and other opportunities. If a company is paying out dividends, we assume it has limited runways of growth ahead, otherwise, why would it not retain it? It is not always the case, a lot of mature companies with healthy balance sheets, and minimal to no debt spit out huge amounts of free cash flow and it makes sense to return it to shareholders and not let it build up.

I am always cautious when I see a rather high dividend yield, it often resembles a company that has a sharply declining share price as the yield is directly related to what a company pays out and the current share price.

What is the Dividend Yield formula?

• Dividend Yield = Annual Dividend Per Share ÷ Current Share Price
• Multiple the decimal x100 to get the %.

The formula in action. Assuming a current share price of $50 and the company pays out an annual dividend per share of $5, the dividend yield would be 10%. The formula 5 ÷ 50 = 0.1 x 100 = 10%

How to use the Dividend Yield?

Let’s use a simple example to understand how the dividend yield is calculated and how we can assess a business’s performance based on its payout and whether it fts our objective as an income investor. Consider two mature companies with strong balance sheets, both paying out dividends. Our first step would be to identify the company with the better dividend yield, and then we can evaluate that company further.

Dividend Yield	Company A	Company B
Dividend Per Share	$1.97	$0.89
Share Price	$22.75	$13.50
Dividend Yield %	8.65%	6.59%

We can see that Company A has a better yield than Company B. It is not a matter of going with the higher yield, we need to understand how the yield has evolved over time and whether it has been consistent. If we dig up the past 4 years of Company A and investigate further it will give us a better understanding of the yield and its reliability.

Company A	2020	2021	2022	2023
Dividend	$1.24	$1.59	$1.65	$1.97
Share Price	$19.48	$20.65	$21.20	$22.75
Dividend Yield	6.36%	7.69%	7.78%	8.65%

In this case, if we look back over Company A and its dividend yield we see consistency, a gradual increase, all reflecting stability. If we had a lot of lumpy years, then it becomes a lot less reliable. For example, say one year it was 7.69% then the next year it was 1% then the following year 3%. As an income-focused investor, we would look at this and perhaps pass up the investment based on the inconsistent dividends.

If a company’s dividend yield has been steadily increasing over time, the changes may be considered positive if it has been caused by an increasing dividend payout. But if the increase is from a declining share price, then that becomes concerning. Sometimes the yield of a declining share price will remain the same as a company with great prospects. Let’s take a look below and compare two companies, one with a rising dividend payout and the second company with a declining share price but stable dividend.

	2021	2022	2023
Company A
Dividend Per Share	$1.00	$1.25	$1.50
Share Price	$25	$25	$25
Dividend Yield	4%	5%	6%
Company B
Dividend Per Share	$1.50	$1.50	$1.50
Share Price	$37	$30	$25
Dividend Yield	4%	5%	6%

In this highly simplified example, we can see the changes of both an increasing dividend and the impact on the yield and a declining share price with a stable dividend. Both yields remain the same, one company is rising and has growth prospects the other has a declining business but may still have cash. It is important to closely investigate how the yield is formed and whether it is from a positive or negative trend.

Understand how the DY is formed.

Cyclical businesses can also have very lumpy dividend yields. For example, as the iron ore price increases a lot of mining companies that hoard large amounts of the commodity then generate significant profits which in turn increases the yield dramatically. This often happens in the mining or oil sector with companies that store large deposits. As the commodity comes into favour of the economic cycle those companies become very profitable and therefore have increasingly high dividend yields before the cycle slows down.

I held rare earth metals companies in my early investing days, businesses that had rarely paid out dividends. Suddenly Electric Vehicles fuelled the demand for more batteries and those companies that held the metals required to make batteries began to cash up. One of the companies for about 18 months went from a yield of 1.5% to 14% before it came crashing down.

Investors need to understand the business cycle and what stage the company is to determine if a yield is good and even if a dividend should be paid out.

Stability and track record are key for income investors. If dividends are a core part of your investing strategy the track record is important. Don’t be attracted to solely finding high yields, for a season you end up getting a slightly better return but can you count on it? If a company that has a high yield gets into trouble as it often does, the first thing to cut is the dividend, which often always leads to a share price drawback as people offload due to unmet expectations, not only is the yield then gone your capital could be at risk.

I do find small-cap companies paying out dividends, often it is related to tightly held capital structures amongst family or founder-run operations and it is a way for them to draw profits without diluting shareholders or taking large salaries.

In Summary…

The total share return over longer time frames can often be attributed to capital growth and dividend reinvestments. Dividend reinvestment plans are a great way to fuel long-term growth. If you don’t need the cash, taking payment in additional shares compounds incredibly well.

If I were to shift to income-focused investing (I may later) I would be looking for mature companies that have long track records of consistently paying out dividends. I would look for leaders in their field, a competitive edge to protect the dividend, strong balance sheets and management skin in the game.

I have found the latter to be an important consideration. The reason is management with a lot of inside ownership will of course favour getting paid cold hard cash by way of dividends so if that has been consistent and management is used to it, then it is not always in favour of being scrapped. Companies are reluctant to cut dividends, and an announcement to cut a dividend is usually never received well by the market. This is why paying attention to the Payout Ratio is important.

Income investing and analysing dividends are all based on what type of investment strategy you have implemented. Dividends play a crucial role in the market, if income is your priority, then finding the companies with track records is the key. If income is also important to fund your life, then stability with slightly lower yields is going to be better than higher yet inconsistent and lumpy yields.