Understanding And Calculating A Dividend Yield

To estimate the current income level from shares we can calculate the gross dividend yield (which means that it is calculated free of tax).

Where D0 = the dividend paid during period 0

and P0 = the share price of the stock at the end of time period 0

Gross Dividend Yield = D0 divided by P0

This may not be a useful guide to the likely future return from an investment in the company. It is actually applicable to a potential investor that is thinking about purchasing stock in a company.

The thought process goes something like this: Knowing the price the stock is currently trading at in the market, and the amount of dividend paid out at the end of the last financial year, how much income can I expect this year if the same amount of dividend is paid out?

Mentally at least, this helps to compare the decision to buy with other things like a bank account.

As we know, there are two potential sources of financial return from a stock holding. The first is the the potential gain or loss from price movements. The second is the dividend yield. But this ratio only provides us with information about the income and not the capital.

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It is also worth noting that unlike a fixed income investment, the income stream may change. The directors may decide to increase or reduce payment and so D0 (shown above) may prove to be a poor indicator of the following year, D1.

Why pay money out?

There are also potential pitfalls when comparing the income stream yields of different companies. The management of the companies being compared may have entirely different opinions about the worth of paying out earnings to owners which will be reflected by differing policies.

Warren Buffett and Berkshire Hathaway are a great example of this. Buffett knows that over the long-term he can grow money by around twenty percent per year, and that most people cannot do that themselves. Therefore, why make an annual payment when their financial interest will be enhanced by keeping the money within the company and letting him continue to compound it? If an investor does not want their money compounded like that, they can simply sell their holding. For this reason the company has never made a payment to shareholders.

As the price of the company's stock moves, the dividend yield also moves - since it is measured against a fixed number. It is therefore possible for this measurement to get substantially better or worse over the course of a year.

If it changes...

Once paid, the dividend of a company is essentially fixed until the next announcement is made. This means that calculating the dividend yield is not always an accurate number. What happens if they don't pay one next year?

Should a company cease to pay a dividend, especially if it has paid one every year for years - or even decades - there will almost certainly be implications for the management team. Major positions in the stock held by income and pension funds may have to be sold and there will very likely be a change in the supply and demand of the stock in the market. This will probably result in a falling share price, which can lead to lower bonuses and payments to management and sometimes, the end of their tenure. All this because of the annual dividend.