Tuesday, March 4, 2008

Dividend Yield Investing For Beginners

What is a dividend yield and how can beginners use it in their stock market investing?

Dividend yield is one of the handy fundamental analysis tools we can use when scanning the stock market for good value stocks to buy. It simply measures the cash return an investor can expect in the form of dividends on in investment in any particular stock. In my last post I discussed price to earnings ratios as a way to value stocks and dividend yield can be used in conjunction with the p/e ratio. In fact Benjamin Graham was a proponent of both of these measures.

How To Calculate Dividend Yield.

Like the price earnings ratio, the dividend yield of most stocks is published in financial newspapers and online on websites like Yahoo Finance. However the dividend yield formula is very simple and easy to calculate yourself. Here is the formula:

Dividend Yield = Dividends Per Share / Share Price

As an example, if a company pays an annual dividend of $2.00 and the current share price is $100 then the dividend yield calculation would be as follows:

Dividend Yield = 2 / 100 = 0.02 or 2%

So in the above example, you could expect a cash return of 2% on the hypothetical company at the price quoted. Of course as the price of a company's stock fluctuates, so does it's dividend yield. A higher stock price pushes the yield down and a lower price will raise it. You will notice that I said cash return above. By this I mean the income you will receive from the investment each year. On top of that, you would expect the capital value of the stock to appreciate. That is, you want the stock price to go up so that ultimately you will make a capital gain when you sell the stock.

So How Can You Use Dividend Yield In Your Stock Market Analysis?

The simplest method to do this would be to just buy a group of stocks with the highest dividend yield as listed in your local financial press. In doing so, you should end up buying the best value stocks on offer at a given time and receive a handy annual income from your stock market portfolio at the same time. But what might the pitfalls be with this method?

One of the first things you might like to check is the payout ratio or times covered figures. The dividend payout ratio is the percentage of annual profits paid out by a company as dividends. Check for companies with payout ratios over 100% - this means they are paying out more in dividends than they are earning. There may be a legitimate reason for doing this in the short term, but over the long term it's not sustainable. Dividend times covered is simply another way of expressing this ratio. It indicates how many times a company's profits cover their dividend. In this case a measure of less than 1 again indicates that they are paying out more than they're earning.

Another thing to consider is what the average dividend yield is. While the return may look good in the most recent year, you will need to look at what was paid out in years past? It could be that the company has paid a larger than normal amount in the most recent period and that this is not expected to continue. This will sometimes explain an unusually high dividend yield.

The main problem with high dividend yields is that it usually means the market doesn't think much of the company's stock. This could be because the company is not expected to exhibit very high levels of profit growth in the years ahead. Or it could be because the company is experiencing financial difficulties and is therefore considered to be a high risk proposition. Whatever the reason, it is usually a result of negative market sentiment.

But this is the type of situation in which value investors may be interested. A value investor may see the high dividend yield (and therefore relatively low share price) as a buying opportunity. A value investor may see the company's difficulties (whatever they may be) as temporary in nature. They may expect to see considerable share price appreciation once the uncertainty is passed.

Another option in dividend investing for beginners is to find high dividend yield mutual funds. Some funds specialize in this area and as such can be well suited to investors looking for income but who don't have the capital, the confidence or the time to enter the stock market directly.

When Is A Low Dividend Yield Good?

There is a school of thought that says that high dividend yields are an indication of a poor quality business. If management have adopted a dividend policy which sees the bulk of profits distributed to shareholders, it means they don't have any more profitable ways in which to reinvest it in the business. I think Warren Buffett is an advocate of management retaining earnings within the business when they can continue to generate high returns on invested capital. He believes that shareholders will benefit more in the long run from growth in the business than they would if earnings where distributed. And I read somewhere that Berkshire Hathaway has only paid 1 dividend under Warren Buffett's leadership.

Measuring Stock Market Strength.

Dividend yields may also be used as an average to measure the relative strength of the stock market over time. The dividend yield of the Dow Jones Industrial Average or the S&P 500 has been used as an indicator of the overall value of the market. At market peaks, the average sinks below 2%, whereas during extreme lows it's been known to creep into double figures. Just keep in mind when comparing figures that payout ratios tend to be lower now than they've been in years gone by.

Hopefully this article has given you some useful background to another tool you can use in your fundamental analysis. Beginners in stock market investing can now add dividend yield to their fundamental analysis toolkit.



The only problem that I have with dividend investing is this to many stock dividend income investors are tempted to reach for those stocks with the very highest yields. This is a mistake a stock with a very high yield and by high I mean 9% or 10% or higher is more than likely having some very serious problems that could result in a drastic reduction of the dividend or even its elimination' which would most likely result in a very large drop in the price of the stock.


Stock dividend investing can be an excellent way to build wealth long term.