Too embarrassed to ask about this key feature of investing? A dividend yield is a portion of a company’s profits that is paid out to shareholders. Each year, managers must decide how much of each year’s profits will be paid out to shareholders in the form of dividends – usually once every quarter – and how much will be retained for business growth.
For example, if the profit (after tax) is $100,000 and $50,000 is paid out as cash dividends, then only $50,000 can be kept back by the directors for growth. This is why some companies grow quickly, but pay low dividends (typically technology companies) while others offer high dividends but low growth potential (such as utilities).
The dividend yield on a given stock or share index is measured by the dividend yield. It is the last annual dividend, divided by the current share price as a percentage.
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Companies don’t actually have to pay dividends
It is important to understand that companies do not have to pay dividends. Just because they make a payment this year, doesn’t mean they have to next year. A company can change its dividend based on how profitable it was last year; whether it needs to retain excess profits to invest in maintaining or growing the business; Or whether it has more cash than it needs and wants to make an additional one-time payment to shareholders (often called a special dividend). So we have to take this into consideration.
To get a more complete picture, dividend yield can be calculated based on what the firm has paid over the past 12 months or calendar year (sometimes referred to as trailing or historical dividend yield) or the amount it will pay. Next 12 months (a forecast or forward dividend yield).
Trailing yields reflect what has actually been paid – but past dividends may not be sustainable. Forecast yields reflect any changes in analysts’ expectations – but forecasts are unreliable. Investors should look at both, but not rely solely on either to make their decisions: You need to think about a firm’s long-term prospects for dividends, including any signals the market is sending.
Red flags you should monitor
A firm with a very high yield may seem cheap, but it may indicate that investors expect the dividend to be cut. In other words, sometimes the yield is high because no one believes it will actually pay. Meanwhile, a firm trading on lower current yields can still be attractive if dividends are expected to grow rapidly in the years ahead.
It is true that generally speaking, companies do not want to reduce their dividends. A dividend cut is almost always a very obvious sign that something has gone wrong, and it often results in board members falling on their swords (or being pushed). But it can and does happen.
It is therefore important to safety-test the dividend, to check how sustainable it is – especially if the dividend yield looks particularly large compared to the rest of the sector.
Understanding cover and payout ratio
There are several ways to check dividend sustainability. You can look at “dividend cover” or “payout ratio”. Dividend cover measures the number of net profits available for distribution over dividend payouts. You calculate this by dividing earnings by total dividends paid, or alternatively, you can divide earnings per share by dividends per share – either will give you the same answer.
A firm that makes $10m in profits and allocates $1m to dividends has a cover of ten and a firm that makes $25m but pays out $12.5m in dividends has a cover of only two.
Although the cover generally differs across sectors, theoretically the higher the figure, the more protected the dividend. A dividend that is well covered usually signals that a company has sufficient capital to pay dividends. But that doesn’t mean the company can actually pay dividends, actually will.
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