An Introduction to Dividend Yield
If you are investing in dividend stocks, it is very important that you know about dividend yield. This article will give you an introduction to dividend yield and it will also give you a few pointers on how to avoid stocks with risky dividend yields.
What is dividend yield?
The dividend yield is one of the key metrics that is looked at when an investor is considering investments in various dividend stocks. The formula to calculate dividend yield is very simple. To get the dividend yield, one will simply have to divide the annual dividend amount by the current stock price.
Example of dividend yield
Though the above mentioned formula for dividend yield might have been quite easy to grasp, it is always a good idea to look at an actual example with numbers.
Let us say that a dividend paying stock trades in the market for $20. Now, one might want to know the yield of that dividend stock before they consider it for purchase. A quick look at the financial statement tells the investor that the particular stock paid out $1 in annual dividends. In this case, the dividend yield is very simply calculated as 5%, after the annual dividend is divided by stock price; i.e., $1/$20.
If a stock has a high dividend yield, does it make it a good stock?
A high yield does not make a dividend stock a better stock than a dividend paying stock with a lower yield. If anything, one should be cautious about a high yield dividend stock, for the following reasons.
Some companies will have a high yield on their dividend stock that will look attractive. However, upon closer analysis, the investor might discover that the stock price has recently taken a beating, thereby artificially pushing up the yield. Using the above mentioned example, let us assume that the company had a very poor year, which resulted in the stock price dropping to $10, all the way from $20. Now, if the investor only looked at the dividend yield, which is now 10%, it looks like a very attractive stock when in reality it is a very poor stock, as the stock price has fallen by 50%.
One should also be very careful about choosing dividend stocks that do not have a long history of paying dividends. Dividend stocks are attractive only when the company has paid consistent dividends, over a long period of time. One of the most ideal dividend stocks is Microsoft, which has been very solid with dividend payments, even during tough times.
This does not mean that dividend stocks with a short history are no good. It is just that one has to proceed with caution when they are buying dividend stocks that do not have an established track record.
After considering the track record and dividend yield of a stock, one must also look at the future potential of a company. Will it remain profitable? Will it continue to grow? Will it generate enough cash to keep paying dividends? These are just some of the questions that need to be answered before one picks up a dividend stock.