dividend yield

Dividend yield is a term that comes up often when you are helping your clients build investment portfolios. If you want to offer sound advice and help your clients achieve their income goals, learning about this financial measure is vital.

In this article, Wealth Professional Canada will discuss what dividend yield is, how to calculate it, and how to interpret it for your clients. We will also look at what makes a good dividend yield as well as some limitations of this metric.

What is dividend yield?

Dividend yield is a simple way to show the dividends paid by a company as a percentage of its current share price. It is one of the most common measures of return for shareholders who want to know how much cash income they might receive from their investments.

Dividend yield is an important measure for your clients who are looking for steady income from their portfolios rather than just capital gains.

Watch this video to know more:

Dividend yield is also an essential metric in fundamental analysis, as it can help investors assess the income-generating potential and financial health of a company.

What are dividends?

To better understand dividend yield, you must also know what dividends are. Dividends are profits that companies share with their stockholders. Not every company pays dividends. Those that do are usually more mature and stable, with consistent income and less need to reinvest every dollar back into the business.

Most dividends are paid every few months, but the company’s board of directors can raise or lower them at any time. Learn more about dividends and feel free to use our dividend calculator in this guide!

How to calculate dividend yield

Dividend yield gives your clients a way to compare the income potential of different stocks, regardless of their share prices. It is a percentage that helps your clients see which investments might provide the most cash income for every dollar they invest. The formula for dividend yield is straightforward:

Dividend Yield = Annual Dividend Per Share / Current Stock Price

For example, if a company pays an annual dividend of $2 per share and its current market price is $40 per share, the calculation will look like this:

Dividend Yield = $2 / $40 = 0.05 or 5%

This means the dividend yield for investors is five percent. In other words, for every $100 invested, your clients would expect to receive $5 in dividends over the year, assuming the dividend and share price remain unchanged.

Dividend yield sample scenario

Suppose that Client X is evaluating an investment opportunity in Company YZ, whose shares are currently trading at $80 per share. Company YZ pays a semi-annual dividend of $1.20 per share, totaling $2.40 per share annually.

This means that for every $100 invested in Company YZ, Client X can expect to receive a dividend yield of three percent, not accounting for any changes in the stock price.

Why dividend yield matters for investors

For many of your clients, especially those who rely on investment income, dividend yield is a key figure. It shows how much income they might expect from their investments without having to sell any shares. This is vital for anyone who wants to supplement their income with dividends.

Dividend yield can also help your clients compare different stocks. For example, suppose Company A pays a dividend of $0.15 per share and trades at $10, while Company B pays $0.75 per share but trades at $100. An investment worth $100 in Company A would get your clients a $1.50 quarterly dividend, while the same investment in Company B would only get $0.75.

This shows why it is important to look at dividend yield, not just the dollar amount of the dividend.

What is a good dividend yield?

There is no single answer to what makes a good dividend yield. Dividend yields can vary widely across industries and companies. Mature, stable companies with predictable cash flows often have higher dividend yields. Fast-growing companies, especially in sectors like technology, might have lower yields because they reinvest profits to grow their market share.

A good dividend yield depends on your clients’ investment goals, risk tolerance, and the overall makeup of their portfolios. You can advise your clients to look for yields that are in line with industry averages or slightly above, but not so high that they raise red flags.

High dividend yield is not always a good sign. Sometimes, a company’s share price drops sharply, which can make the yield look high even if the company is struggling. For example, if a company’s stock price falls but it keeps paying the same dividend, the yield will go up. This might look attractive, but it could be a warning sign that the company is in trouble.

Financial advisors should also watch out for companies that borrow money to keep dividends high or choose to pay dividends instead of reinvesting in the business. Both situations can hurt the company’s future performance and put the dividend at risk.

Limitations of dividend yield

While dividend yield is a useful metric, it has several limitations that financial advisors should keep in mind:

1. Dividend yield only shows potential income

It does not account for capital gains, which can be a major source of returns for investors. If a stock’s price goes up, your clients benefit from the increase in value. However, this will not be reflected in the dividend yield.

2. Dividend yield can be inflated by a falling share price

If a company’s stock price drops, the yield goes up, but this might be a sign that the company is struggling. There is even a term for companies that use high dividend yields to attract investors to weak stocks: dividend value traps. These are companies that look attractive on the surface but might not be good for long-term investments.

3. Some companies might take on debt to maintain high dividends

Others might also avoid reinvesting in the business to get the same outcome. This can make the yield look good in the short term but hurt the company’s long-term prospects.

4. Dividend yield calculations can vary

This depends on the time frame and method used. There are calculations that use the total dividends paid during the most recent fiscal year. Others use the past four quarters, and some extrapolate from the most recent dividend. This can make it harder to compare yields across different companies.

How to interpret dividend yield

When discussing dividend yield with your clients, it is critical to put the number in context. A stable or rising dividend yield can be a sign that a company is confident in its financial health and future cash flow. However, a very high yield might be a red flag, especially if it is caused by a falling share price or unsustainable business practices.

Encourage your clients to look at dividend yield as just one part of a broader analysis. Other factors to consider include the company’s overall performance as well as its:

• profitability
• liabilities
• growth prospects
• position in the industry

A company with moderate yield but strong fundamentals might be a better investment than one with a very high yield and weak financials.

It is also helpful to compare dividend yields across similar companies in the same industry. This can give your clients a sense of what is normal and help them spot outliers that might require a closer look.

Watch this clip to learn more:

Let’s look at a few scenarios that one might encounter when discussing dividend yield with their clients:

Company A pays a high dividend, but its share price has been falling

The dividend yield looks attractive, but the company’s long-term prospects are uncertain. In this case, it is necessary to dig deeper and understand why the price is dropping.

Company B pays a modest dividend, but its share price has been rising steadily

The dividend yield might be lower, but your clients could benefit from both income and capital gains.

Company C does not pay dividends at all but is growing rapidly

For some clients, especially those focused on long-term growth, this might still be a good investment.

These scenarios show why it is vital to look beyond the headline yield and consider the bigger picture.

Using dividend yield in portfolio construction

Dividend yield can be a useful metric when building portfolios for your clients, especially those who need regular income. However, it should not be the only factor you consider. Try evaluating dividend yield with other measures such as return on assets (ROA), free cash flow (FCF), and Price-to-Earnings (P/E) ratio.

Diversification is also important. Relying too heavily on high-yield stocks can increase risk, especially if those companies face financial challenges. Mixing dividend-paying stocks with growth stocks and other asset classes can help your clients achieve a balance between income and long-term growth.

The latest dividend yield news from Wealth Professional!