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What is Dividend Yield?
Dividend Yield is a financial ratio that measures the quantum of dividends that the company pays to its shareholders each year relative to its current market price per share. In simple terms, it is a percentage of the annual dividend per share to the current market price of the share.
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Generally, high dividend-yielding stocks attract investors. Some investors, like retirees, are highly dependent on dividends for their income. For such investors, this ratio can have a meaningful effect on their portfolios. At the same time, a low dividend yield ratio can be due to low profitability, higher debt, etc.
Similarly, dividends are also paid in mutual funds, where investors can specifically opt for dividend yield mutual funds. The fund portfolio invests in stocks that have the potential to pay high dividends. When the companies issue dividends, the fund manager adds these profits to the fund’s NAV. The dividend payouts in a mutual fund can be monthly, quarterly, half-yearly or yearly. Furthermore, dividend-oriented mutual funds are classified as:
- Dividend payout funds (receive dividends directly in a bank account)
- Dividend reinvestment funds (reinvest the dividend in the same fund or any other fund of the same fund house)
Recommended Read: Dividend Reinvestment Plan
How to Calculate Dividend Yield?
The dividend yield is calculated by dividing the amount of dividend per share by its market value per share. The formula is –
Dividend Yield = (Annual Dividend Per Share / Current Market Price of the Share) *100
Example: Company ABC is trading at Rs.45. For one year, the company paid consistent quarterly dividends of Rs.0.30 per share.
Dividend Yield Ratio = 0.30+0.30+0.30+0.30 / 45 = 2.7%
Therefore, an investor will earn 2.7% on shares of Company ABC in the form of dividends.
Note: Investors must compare this ratio for companies within the same industry. Otherwise, the average yield may vary significantly between industries.
Interpretation
Dividends are essential for investors looking for passive income from their investments. This ratio gives the productivity of the investments. Also, dividends are a sign of stability because only profit-making companies can pay dividends. Furthermore, a company that pays dividends regularly is considered mature as it shows liquidity control. Value investors prefer these companies as they tend to perform well even during market lows.
This ratio provides an idea about the company’s growth prospects for the future. Also, not all companies with high dividend yield ratio are worth investing in. For instance, if the market price of a share is falling, the dividend yield ratio becomes more attractive. In such a case, the company may not be a good buy. Therefore, it is vital to understand the stability of dividend yield and other fundamentals of the company before purchasing a stock.
Advantages and Disadvantages of Dividend Yield
Advantages
- Investors use the dividend yield to understand if the company can continue paying its shareholders from its profits.
- This ratio helps to compare which dividend stocks investors can purchase. Especially investors looking for a source of income from their portfolio. Through this ratio, they can compare stocks that generate high income.
- This ratio is beneficial during company valuation. It helps to identify the difference between the current and historical level of dividends and understand if the stock is undervalued or overvalued.
- Many potential investors use this ratio as a first step to analysing a company’s cash flow and other operations.
Disadvantages
- One of the major disadvantages of this ratio is that investors use only this factor to determine the company’s potential.
- A high ratio may look attractive, but there may be other associated risks that the company may face in the upcoming years. Therefore, focussing only on the dividend yield ratio for evaluating a company is not always correct.
Therefore, to prevent poor investment outcomes, investors must consider other factors while deciding to invest in a stock.
Dividend Yield Vs Dividend Payout Ratio
Dividend yield is a ratio of annual dividend per share to the current market price of the share. While the dividend payout ratio is the ratio of the dividend per share to earnings per share. Following are the key differences between the two:
| Dividend Yield | Dividend Payout Ratio |
| Dividend Yield = (Annual Dividend Per Share / Current Market Price of the Share) *100 | Dividend Payout Ratio = Dividend per Share / Earnings per Share (EPS) |
| Computes the total dividend income a shareholder gets. | Computes the percentage of the company’s profits that are distributed as dividends to shareholders. |
| A higher ratio indicates that investors can expect better returns by investing in the stock. | A higher ratio indicates the company is fairly distributing its earnings to the shareholders. |
Frequently Asked Questions
Dividend yield is a financial ratio that tells you the percentage of how much dividends the company pays each year relative to its share price. For instance, if the company’s share price is Rs.200 and pays a dividend of Rs.10 every year, the dividend yield will be 5%.
A good dividend yield is enough to meet your current income needs. Experts suggest a yield between 2% to 6% can be a good yield. However, a number of other factors must also be considered to conclude if the dividend yield is good or not. Therefore, investors can consult a financial advisor to help them identify good dividend-yielding stocks.
A high dividend yield may look attractive to investors as they receive a high income. However, a high yield ratio is not always a good sign. Some of the reasons could be that the company distributes high profits to its investors. It is a sign that the management does not prefer to reinvest in the company given the lack of upside. Another reason is that the share price has been falling, showing a higher yield.
The primary importance is for investors looking for passive income from their investments. Also, this ratio indicates the financial health of the company and its future growth potential. High dividend-yielding stocks become more attractive, while low-yielding stocks may seem less competitive relative to their industry.
The income from dividends is tax-free in the hands of the investor. The company pays the dividend distribution tax (DDT) before passing the dividends to investors. Furthermore, dividends from foreign companies is taxable at a flat rate of 25%.
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