What Is Dividend Yield, How To Calculate It And Why Is It Important?

Mutual funds

The dividend yield is a ratio that calculates the amount of cash dividend that a company pays to its shareholders in comparison to the current market value of each share. It is a parameter to measure how much you are earning for every rupee that you are investing in equity. 

If you are interested in value-oriented investing, then you should have a clear understanding of dividend yield. Here’s a detailed rundown on dividend yield, how to calculate it and its importance in investment. Read on!

What is Dividend Yield?

Dividend yield is the ratio that shows how much a company pays out in dividends to shareholders yearly compared to the stock price or market value per share. It is an estimation of return from dividend-only stock investment. Considering the dividend of a company has not been lowered or raised, the yield will grow as the stock price falls. Alternatively, it will drop as the stock price goes up.

Since changes in dividend yield take place in relation to stock price, the dividend yield for stocks that are falling rapidly can appear to be high. New businesses that are small but growing at a fast pace usually pay a lower average dividend. However, big and well-established companies pay comparatively higher dividends. 

Investors are categorised as value-oriented investors or growth-oriented investors. Growth-oriented investors invest in growing businesses while expecting higher capital gains as the business grows in the future. However, value-oriented investors look for stable returns through dividends in addition to capital gains. If you belong to the second category of investor, then dividend yield is useful for you. 

Also Read: How To Grow Your Money With Mid Cap Funds?

Dividend Yield Formula and How to Calculate

The dividend yield is calculated by dividing the money a company pays to its shareholders for owning a stock by the current stock price and multiplying it by 100. So, when someone says high dividend yield, it means that a company pays a generous amount of its profits to shareholders of the company’s stock in the form of dividends.

You can use the following formula to calculate the dividend yield of a particular company stock: 

Dividend yield= Dividend per share / Market value of each share

All you have to do is to take the dividend provided by a company for each share and then divide it by the market value of each share. However, businesses can sometimes declare dividends in the form of gross dividends. 

Let’s take an example to understand this calculation in detail. 

 Suppose a company has declared Rs. 10 lakh in the form of a cash dividend. It will pay this amount in the current year. It has a total of 10,000 outstanding common stock. So, the amount of dividend for each share will stand at:

Dividend for each share = Total cash dividend / Outstanding common stock

So, here it would be = 10,00,000 / 10,000 = 100

The dividend for each share of this company would stand at Rs. 100. Now, to find its dividend yield, you need to divide it by its current market price. Let’s assume the current market price of each share of this company in question is Rs. 1,000. 

As per the formula, the dividend yield of this company would be:

 = 100 / 1000

= 0.1 or 10%

Is Investing in High Dividend Yield Stocks Good?

Investors could benefit from investing in high dividend yield stocks. These can double as a steady source of income for investors. Often, dividends earned passively are reinvested by investors in the stock market to generate more returns. The benefits of high dividend yield stocks are that investors can earn more via share price appreciation as well as through distribution.

However, you need to pay heed to the following factors before investing in high dividend yield stocks: a) consistency in paying dividend b) growth in the percentage of dividend

Importance of Dividend Yield

By analysing the dividend yield, you can find out the right investment opportunities as per your income needs. Here’s how a dividend yield can help you with your investments: 

• Accurate comparison of stock
  The dividend yield will make it easier to make an accurate comparison of the relative value of the share price of a stock with its peers. If its dividend yield is more or less at par with its sector peers, then it’s a suitable option for investment. 

• Assess the financial strength of a company
  Another significant benefit of dividend yield is that it helps to assess the financial prowess and stability of a business. High dividend yield stocks are generally from mature companies offering dividends that grow year over year. 
  
  When a company hikes its dividend and consequently the yield ratio consistently, it indicates the company is performing well. A higher dividend yield shows that a business can afford to pay more profits to its shareholders. 
  
  Those companies that provide regular dividend hikes are often considered mature companies. As value investors tend to prefer such companies, they are capable of performing well even during market volatility. 

Also Read: Which Are The Best Debt Funds In India?

Dividend Rate vs Dividend Yield

The companies with heavy cash flow who don’t need to reinvest, share the profit earned among the shareholders. The companies mostly belong to the healthcare, food & beverage and energy sectors. 

Dividend is the profit an investor earns from stock or dividend-yielding assets during that financial year. It is expressed in rupees. 

A dividend yield, on the other hand, is the ratio between the company’s annual dividend per share and the current share price. It is represented in percentages. 

Pros and Cons of Dividend Yield

Here are some pros and cons of a dividend stock:

Pros

• Passive income mode 
  Dividend payout to investors actually goes into the pockets of the investors. Hence, it works as a passive income for the investors. 

• Return on investment 
  If the company is doing well, the share price will eventually rise with time. This gives an investor an additional return on investment. 

• Dividend reinvestment
  An excellent method to make the best out of dividends earned is to reinvest them. Reinvestment of dividends will give you the benefit of compounding returns. It is also known as the “dividend snowball effect” and is a powerful tool for building wealth over a long period. 

• Shield against inflation
  Inflation is the constant increase in the price of the goods and services we consume on a daily basis. Investment in dividend stock can provide a barrier against inflation. 

• Favourable tax treatment 
  Tax treatments are subjective to every individual, depending on the situation and the object. However, it is observed that dividend stocks have gotten favourable tax as compared to the other sources of income. 

Cons

Now that you have known about the advantages of investing in dividend stocks, here are some of the drawbacks you should know about. 

• Risk appetite 
  When compared to other stocks, dividend stocks involve more risk on investment. Share prices fluctuate frequently, and they might drop a lot at times.

• Sector specification 
  Dividend stocks tend to perform well in some sectors when compared to others. Hence, investors should be careful about portfolio segmentation. A diversified portfolio will be able to hold your wealth better in times of economic crisis. 

Final Word

It is a general notion that companies with high dividend yields are better investment options. However, that is not always true. If the market price of a company’s share drops, its dividend yield becomes attractive. Here, the company would not be worth investing in. However, dividend yield remains one of the major signs to study before you invest in any stock. 

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FAQs on Dividend Yield

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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.