A stock’s dividend yield measures how much investors receive in annual dividends as a percentage of the stock price. While dividends are widely followed, investors should take caution when using them to evaluate stock investments.

A stock’s dividend yield is equal to the annual divided by the stock price. It measures how much investors receive in dividends as a percentage of the stock price. 

  • Question: A company pays a $0.60 quarterly dividend. Its current stock price is $200. What is its dividend yield?
  • Answer: $0.60 * 4 = $2.40 per year. $2.40 / $200= 1.2%.

When are dividends paid out?

There are several key dates to know when it comes to dividends, as shown here for Apple.

  • The declaration date is the date the company announced the dividend. It simply informed investors that a dividend will paid on a certain date.
  • The ex-dividend date is the cutoff date to receive the stock, meaning that holders of the stock before that date are entitled to the dividend, while owners past that date are not. On the ex-dividend date, a stock should fall by the amount of the dividend, but due to market and other factors, the decline rarely matches the exact dividend amount.
  • The dividend is actually paid out a few days later on the dividend payment date.

Why is the dividend yield watched so closely by investors?

Many investors focus on dividend yield as they seek regular income. Investors, especially retirees who rely on dividend and interest income, hope to receive consistent and growing dividends from their investment in the company while also seeing capital appreciation.

Additionally, many investors assume that companies that pay higher dividends generate higher free cash flow. We will explain below why this is not necessarily the case. 

Should I use the dividend yield to determine whether to invest in a company? 

The dividend yield should only be used in the context of a much large analysis on the stock. It should not be a significant standalone factor on its own merit for the following reasons:

  1. Companies with higher dividend yields may have high financial leverage (high debt relative to the total company value) and can, therefore, be riskier. Companies with high financial leverage are generally not well-positioned to weather a financial downturn. 
  2. The dividend may be unsustainable. The company’s cash flow may decline and it might have to cut the dividend. Additionally, it may be funding the dividend through increased debt loads, as alluded to above, and therefore it may not be sustainable. For example, CBL, a REIT that owns second-tier malls, has a 25.2% dividend yield. This high yield reflects the market's belief that the dividend will not remain that high. It also reflects the company's high financial leverage, as mentioned in the point above.
  3. Companies with lower dividends or no dividend at all may be using excess cash flow for other productive purposes, such as acquisitions, capital investments, and share buybacks. Those activities may be “value add” initiatives for the company and it has therefore chosen to reduce or forgo its dividend. For example, Google does not currently pay a dividend at all (hence, its dividend yield is 0.0%). This certainly does not mean that Google doesn't generate profit or free cash flow. In fact, it generated an astonishing $30.7 billion in net income in 2018. So what is Google doing with its excess cash flow? It is currently spending in R&D, capital expenditures, and share buybacks, and increasing its cash balance.
  4. As a logical following from the point above, companies paying high dividends may not have other high value add uses for its capital, so its high dividend might be a signal its growth is peaking. 

Based on the factors above, a high dividend yield may be misleading. However, it can be if the investor conducts significant research - including analyzing financial reports, the competitive landscape, industry prospects, and more - and concludes that the dividend yield is sustainable and provides for a higher return at the same level of risk than alternatives. 

To emphasize, it is highly recommended that further research be done beyond comparing dividend yields. 

If the dividend yield isn’t a reliable investment criterion, what should I use?

The most complete method for evaluating the worthiness of a stock is the Discounted Cash Flow method of valuation. A DCF model projects the company’s future cash flows and discounts those cash flows to the present value. After making certain adjustments and calculations, you can derive a value per share and compare it to the market price. 

A DCF model incorporates the key components of an investment’s viability. We include our projections of company growth in perpetuity and use a discount rate to account for the riskiness of those cash flows. We take into account excess assets and liabilities the company has and total diluted shares to determine a value per share. 

Learn Finance & Investments in Hands-on Classes in New York

At NYIM, we offer several hands-on classes to increase your knowledge and skill in finance, investments, and financial modeling.