Is a High or Low Dividend Yield Better?

Is a High or Low Dividend Yield Better? Common sense would tell us that a 10% yield on one stock is much better than a 5% return on another. After all, the return on investment for the first stock is twice that of the second stock. While this logic seems reasonable, you may be surprised to find out the stock returning 5% will probably make for a much better investment.

In order to truly tell if a high or low dividend yield is better, you must first understand how the ratio is calculated and what it actually is telling investors.

The dividend yield of a company is a financial ratio that represents the amount of dividends paid each year in relation to its current share price. The calculation lets investors known how much cash a company is paying out each year in dividends based on the current share price of a stock. It also helps interested investors know what type of return on investment they can expect.

The following equation can be used to calculate a company’s dividend yield.

Dividend Yield = Annual Dividends per Share / Current Share Price

If a company paid out $2.00 in dividends over the past 12 months and is currently trading at $50 per share, the dividend yield would equal 4.0% ($2.00/$50.00). If you are not up for calculating the yield of a stock, you can certainly find this information on almost every financial website that reports information on the stock market.

The return on investment is constantly fluctuating for any stock that pays dividends each and every day. Why does this happen? As we learned above, the dividend yield uses the company’s current share price as the denominator of the equation. Since that price is constantly moving up and down during the trading day, the yield is moving along with it.

For example, let’s say that the price per share of the stock dropped from $50 to $45. In this case, the actual yield would increase to 4.4%. On the other hand, if the stock rose to $55 per share from $50, the yield would lose ground to 3.6%. In a normal trading day the ratio probably does not move up or down this much, however over longer periods of time this number can rise or drop quite a bit.

The dividend yield, also commonly referred to as current yield, is probably the most widely used financial ratio by dividend investors. The ratio tells an investor exactly what return on investment (in dividends) they can expect when purchasing the stock at the current market value. While the ratio can be useful, it poses a few problems.

One of the biggest disadvantages of calculating the yield of the company is that is uses past earnings and current share price. This means that the two inputs to the equation are taken from different snapshots of the company’s performance. The annual dividend input is taken from the past 12 months. As we all know, past performance does not always guarantee future performance will be the same.

If the company ends up cutting their dividend and you bought the stock prior to the announcement, your return on investment will have been cut as well.

The other big disadvantage of calculating the yield of a company is that it does not represent any positions you may have purchased. Since the equation uses the current share price in the numerator, the results are always changing. However, the share price you paid to own the stock remains the same until you add more positions to it. This means that the current yield of a stock that you own is not a true representation of what you are earning in dividends. An alternative to this is to calculate the yield on cost which is tied to your average purchase price.

Based on what we have learned so far - Is a High or Low Dividend Yield Better? Ultimately, this answer depends on the type of investor you plan to be. However, for the long haul I would put my money on a low dividend yield over a high one any day.

As we have already learned, a high dividend yield is usually the result of a drop in share price compared against past dividends. There is a reason why the share price dropped. It could be the though the company will end up cutting their dividend in the next quarter or some other underlying reason there is trouble with the company. A high dividend yield above 6% or 7% should be treated with extreme caution with any stock.

There are a few exceptions to this rule when it comes to income trusts and energy trusts. Some corporations are setup in the form of a trust allowing them to pass almost all of their profits back to shareholders in the form of dividends. Extreme caution should be used as well when investing in these types of stocks as they can be risky investment choices.

We learned that it is probably better to choose a stock with a low dividend yield instead of a high yield. What is considered a high or low yield? Any stock that has a yield that is more than 6% or 7% will have a difficult time maintaining this payout (with the exception of trusts). When yields rise to these levels, it should be treated as a red flag that there could be underlying problems with the company.