Learn How To Calculate Dividend Yield
Discovering how to calculate the dividend yield for a stock is one of the best things a new investor can do because it allows an immediate, back-of-the-envelope comparison to the cash yield you would expect from owning a share of stock to the cash interest coupons you would expect had you selected a bond instead.
In fact, not only does dividend yield allow you to compare cash yields on a stock investment to an investment in bonds, it can provide a useful comparison to certificates of deposit, money market accounts, money market mutual funds or real estate projects as well.
The process of calculating dividend yields is fairly straightforward. But there are a few tips and tricks I'll pass along to help you make better sense of the reasons dividend yields matter, and how dividends should compare to alternative sources of passive income.
The Definition of Dividend Yield
When a company generates a profit, the board of directors often decides to mail out some of those earnings to the shareholders. For example, when I originally wrote this article on Jan. 28, 2014, over the past 12 months, each share of McDonald's Corporation generated $5.55 in after-tax profit, and the board decided to mail $3.24 per share out to the stockholders in cash. If you owned 100 shares, you would have received $324. If you owned 100,000 shares, you would have received $324,000.
The money mailed to the shareholders is called a dividend. The dividend yield is a financial calculation that tells you how much money you will earn for every dollar invested in the stock at today's price based on today's dividend rate. An alternative — and interesting — concept is something known as dividend yield on cost, which we will talk about later.
How to Calculate Dividend Yield
To calculate the most common form of dividend yield, you take the per share cash dividend — keeping with our McDonald's example from several years ago, it would have been $3.24 — and divide it into the market price of the stock. When this article originally went to digital press, shares of the Big Mac empire closed at $94.07. Thus, to calculate the dividend yield we would take:
Cash Dividend ÷ Stock Price = Dividend Yield
So in this case, it would be:
$3.24 ÷ $94.07 = 0.0344 or 3.44%
This tells you that if you put $10,000 into McDonald's shares, you'd expect to collect $344 in dividends per year at the 2015 rate. If you put $1,000,000 in McDonald's, you would expect to collect $34,400 in dividend income per year at the current rate. The 10-year Treasury bond yield, in contrast, was providing a return of 2.78% at the same time.
Dividend Yield on Market vs. Dividend Yield on Cost
The current dividend yield is only half the story. Unlike bond yields, which are based a fixed rate of interest paid for the life of the bond, dividends for most successful companies increase over time.
Let's continue using McDonald's as an illustrative case study. Take a look at the dividend it distributed to shareholders between 2007 and 2012.
Note: If you come across this article at some point in the future, don't worry because there is no need to update the figures as the basic concept behind dividend yield remains the same no matter the year and no matter the specific dividend amounts you uncover in your investment research process:
- 2007 = $1.50 dividend
- 2008 = $1.63 dividend
- 2009 = $2.05 dividend
- 2010 = $2.26 dividend
- 2011 = $2.53 dividend
- 2012 = $2.87 dividend
If you bought McDonald's stock back in 2007, you've watched your dividends increase each and every year. You're collecting far more than you originally anticipated based on the dividend yield on the purchase date. In fact, during that year, the stock averaged almost exactly $53 per share, so imagine you bought a single share.
On the day you paid for your stock, you were collecting $1.50 in dividends on a $53.00 stock, which is a dividend yield of 2.83%. Over the past 12 months, you've collected a dividend of $3.24. Comparing that $3.24 to the purchase price instead of the market price, you can calculate something known as "dividend yield on cost". This calculation shows the dividend yield for the original amount of investment. In this case, you're actually earning the equivalent of 6.11% per year on your original investment.
This can serve as a major driver of change in the stock price.
Companies that make their owners rich do so by continually earning more profit. These businesses often have some sort of inherent economic advantage, like the Coca-Colas of the world, which can raise prices or expand into new markets.
The truly elite dividend payers on Wall Street, those businesses that have raised their dividend payouts to owners each year, without fail, for 25 years or longer, earn a title allowing them to be called a "Dividend Aristocrat". The first list of aristocrats was published in 1989 with a total of 26 companies. Since then, that list has grown, with the current list boasting more than 50 different companies including Chevron, Johnson & Johnson, Kimberly-Clark Corporation, Coca-Cola, Proctor & Gamble, AT&T, Target and Walmart.
McDonald's has expressed a commitment to raising its dividend so much, in fact, that we are now approaching the 40th year in a row that it has sent bigger checks to its stockholders. That puts it in a league of its own among other blue chips on Wall Street. Only a handful of other firms can boast such a sterling achievement.
Update: As I come back and freshen this article on Dec. 27, 2018, I should point out that McDonald's has continued its practice of raising its dividend each year. As a matter of fact, here is the subsequent record:
- 2013 = $3.12
- 2014 = $3.28
- 2015 = $3.44
- 2016 = $3.61
- 2017 = $3.83
- 2018 = $4.19
That means our original hypothetical investor who bought the stock at $53.00 per share back in 2007 has now collected a cumulative $34.31. That means he or she has collected 64.9% of the original cash outlay for his or her ownership stake in McDonald's back in the form of dividends.
Looking at it another way (and this is merely an academic tool as the tax treatment is different), think of the net purchase price as being $53.00 - $34.31 = $18.69.
Is it any wonder so many people are enamored with dividends? Imagine McDonald's declared bankruptcy — an almost unthinkable possibility given its financial strength and wide geographic diversification, but one that could happen in a remote-probability scenario — and the stock went to $0.
In this case, our investor has that $34.31 in cash he or she collected from the dividends. Though still very real, this means the loss itself wouldn't have been nearly as painful. In actuality, the stock price is now $174.03 per share as the market has adjusted to reflect the increased underlying profitability that has occurred during this span of time.
This means our investor would enjoy not only $34.31 in cash dividends but $121.03 in unrealized capital gains for a total profit of $155.34 on each $53.00 invested. To learn more about this concept, read Focus on an Investment's Total Return Not Capital Gains.)
Attractive Dividend Yields May be a Trap
On the flip side of the equation are the dividend traps that ensnare inexperienced investors. These are companies that look like they are going to make you a lot of money by boasting extremely high dividend yields — often many times what the stock market as a whole is offering.
Yet, sophisticated investors are not stupid. They are avoiding the business for a reason. Perhaps there is an enormous lawsuit that could bankrupt the company. Maybe the financials indicate the dividend is not sustainable and will have to be cut.
One defensive move in a situation like this is to look at the dividend yield of a company relative to others in the industry. If there is a single homebuilder offering a 14% dividend yield, something isn't right. Either they are in financial trouble, there was a one-time special dividend that won't be repeated or there is some other factor that you will need to research. A stock quote alone won't suffice.
The Bottom Line
If you're a new investor, you can easily figure out how much money you'll earn for every dollar you invest in a company. You just need today's dividend rate and divide that by today's stock price to get the current dividend yield. Knowing how to calculate this will help give you an immediate snapshot of what you'll make compared to the interest you would earn on another investment such as a bond. This formula is best used if you're trying to choose the right dividend-paying stock for your portfolio.
If you want to see how a stock you currently hold is performing, use the yield on cost calculation.
Jacara does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.