Dylan Lewis: Hey, there, I'm Dylan Lewis from The Motley Fool. In this FAQ video, we're
going to explain dividend yield, how investors can use the dividend yield formula, and at
the end of the video, we're going to go through a nightmare scenario of how investors can
be tricked by a high-yield stock.
Dividend yield is a metric all dividend investors
obsess over. It refers to a stock's annual dividend payments to shareholders expressed
as a percentage of the stock's current price. Now, the actual formula is annual dividend
payments divided by stock price. For example, as of taping, Microsoft’s shares cost around
$167 and the company pays a quarterly dividend of $0.51. If the dividend stays exactly the
same over the next 12 months, investors will receive four dividend payments totaling $2.04.
Dividing that payment total by the current share price, you get a yield of around 1.2%.
Another way of thinking about dividend yield is that, one year from now, if shares of Microsoft
are exactly the same price they are now, investors will have gained 1.2% thanks to the dividend payments.
Now, it's important to realize that a stock's
dividend yield can change over time, either in response to market fluctuations or as a
result of the dividend increases or decreases by a company. In the case of Microsoft, for years,
investors enjoyed a yield of over 2% on their shares, but over the past two years
the company's stock prices almost doubled thanks to its booming cloud business.
So, even though the company has increased its dividend every year for the past couple of years,
the yield is near ten-year lows because the share price has gone up faster than the
dividend payments. That's why it's important to understand the underlying equation for
calculating yield and why it's important to consider yield and total return.
Dividends are just one component of how investors can make money, you should also look at this
total return figure, which takes dividend yield and includes increases or decreases
in share price too. For example, if a stock's price goes up by 5% this year and it pays
3% dividend yield, then your total return is 8%. In the case of Microsoft, in the beginning
of 2019, the yield was roughly 1.5%, but over the course of the year shares went up 55%,
giving investors that bought on January 1st, 2019 around 56% returns; pretty darn good.
With Microsoft, yield went down because shares became more valuable, the opposite can happen
too, a stock's dividend yield can go up dramatically because a company's share price falls. Say,
shares of a stock go from $20 to $10 over the course of the year and its dividend of
$1 stays exactly the same. The company's yield would go from 5% to 10% and it would seem
like an awesome opportunity for investors that haven't been following the company closely.
If they're blinded by the yield, they won't realize that it's only high because the business
is struggling and if it continues to do poorly the company might cut its dividend entirely
and investors could lose even more if the share price continues to fall due to bad business results.
That's why, in addition to looking at yield, you should look at the company overall.
Here's a quick list of things to keep in mind: 1) Do you understand the business? Can you
explain what they do and how they make money? If you can, you'll be able to recognize and
understand the business and how it's doing financially. 2) Is the company growing? Is
the company posting revenue growth and is that growth generally in line with where it
has been in the past? A growing business is more likely to be a healthy business. 3) Is
the business relevant in its industry? This is harder to measure, but the idea here is
that you generally want to own market-leading companies or companies poised to become market
leaders. If an old business is in the process of being disrupted, it probably doesn't make
for a great dividend stock. One way to think about a lot of these factors
and look at it in one digestible metric is to look at a company's payout ratio.
This measures how much a business pays in dividends relative to its net income. The reason we
look at this is that dividend payments are something a company elects to do and if they're
struggling, they might decide to cut their dividends. There isn't a single right figure
for the dividend payout ratio, but the idea here is that you want to look at the number
relative to where it has been in the past for the company and how the company compares
to its peers. If the ratio suddenly spikes unexpectedly, that could be a sign that the
company might have trouble maintaining its payments down the road unless it's able to
bring in more money with its operations. And if a stock's payout ratio is over 100%,
it means the company is paying out more in dividends than it's making in income, which is not sustainable
over the long-term. For a full breakdown on dividend yield and
payout ratio, get our free dividend report over at fool.com/payme. There's a link for
that down in the description. One last thing on dividend yields. There are
special structure businesses, like, real estate investment trusts and master limited partnerships
that operate slightly differently than your average business. They have higher yields
because they're built to share more of their income with their shareholders. Now there
are great REIT and MLP investments out there, but they require using industry-specific metrics
to evaluate. We’ll drop a link to our REIT video in the comments section.
The point is, investors looking at only yield might accidentally buy MLPs and REITs without
realizing it, and that could open them up to complex businesses and complicated tax structures.
That's why item No. 1 on our checklist before was, do you understand the business?
Make sure you do your homework first and don't just scoop up shares of high-yield stocks.
Okay, that's going to do it for this FAQ video. We want to know what you want us to cover next.
Drop ideas down in the comments section below. And if you can do a favor and hit the
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If you want our free dividend investing playbook, head over to fool.com/payme. It's got everything
you need to get started and three starter stocks. Microsoft is one of them, you have
to head to the link to get the other two. Until next time, thanks for watching and Fool on!