What is dividend yield?

A share's dividend yield is the percentage of that share's current market price paid out as dividends each year. It can be a helpful metric to have in your financial toolkit when you're on the lookout for new ASX investments.

First, a quick look at dividends

Dividends enable profitable companies to distribute their earnings to their shareholders. Not all companies will pay dividends. Some may not yet be consistently profitable enough, while others may choose to reinvest their earnings into growing their business.

Companies that pay consistent dividends tend to be popular with ASX investors as they can help generate dependable passive income streams. Mature blue-chip companies with proven track records of success are the most likely to pay out regular dividends to their shareholders.

What is dividend yield?

When companies pay dividends, these form part of the total return you can expect to earn on your investment – in addition to any capital gains you might make from the appreciation in the company's share price. Therefore, it is often important to factor a company's dividend yield into your decision-making prior to deciding to invest.

Dividend yield is the annual dividend payments per share expressed as a percentage of that share's current price. It is a commonly used financial ratio that can give you an idea of how much future income you can expect to earn in the form of dividends based on your current investment.

Divide the annualised dividends by the current share price to work out a share's dividend yield. For example, if a company's shares currently trade for $100, and its annualised dividend payments are $5, its dividend yield is 5%. If the company's shares instead trade for $150, and its annualised dividends are $15, then its dividend yield would be 10%. 

Either way, the formula is simple:

(annualised dividends per share)/(current share price)  × 100%

How often do companies pay dividends?

ASX-listed companies that pay dividends generally do so twice a year in the form of an interim and final dividend payment. The annualised dividend is the sum of the two most recent dividend payments. If the company pays dividends more or less frequently than that, the annualised dividends would be the sum of the prior 12 months' worth of dividends.

Technically, a dividend yield calculated using a share's prior dividend payments is called a 'trailing dividend yield' as it uses historical (or trailing) dividend information as the basis for the calculation.

Trailing dividend yields can quickly become outdated, particularly if a company has recently changed its dividend policy. To get around this problem, some market analysts will also calculate a 'forward dividend yield' based on their forecasts of dividend payments expected over the coming year.

It's important to remember that a share's dividend yield is not set in stone. It can potentially fluctuate a lot over time in response to changes in the company's share price and dividend policy. 

However, the dividend yield can still be a very helpful metric to use when you're trying to work out whether a company's shares are fairly priced and meet your income needs.

Total return

Dividends are just one component of a share's total rate of return – the other is changes in the share price. For example, if you purchased a share worth $100 that had a dividend yield of 5% and its price increased to $110 after one year, you would have gained 10% from the price appreciation, plus the 5% dividend yield, for a total annual return of 15%.

When investing for the long term, it is important to balance these two return components. Companies that already pay a consistently high dividend yield are more likely to be mature, blue-chip companies, so their share prices probably won't unexpectedly skyrocket any time soon. 

Conversely, many junior companies may not currently be profitable enough to pay any dividends, but their share prices will probably be more volatile and are much more likely to shoot up quickly in response to a positive market release.

These two different groups of companies offer very different total return profiles. The blue chips probably won't return much in the way of capital gains, but do offer more dependable passive income streams – which can be measured by their dividend yields.

Smaller growth companies will be less likely to provide reliable dividend income (and perhaps won't have a dividend yield at all) but may instead offer better long-term price appreciation. The group of companies that is right for your portfolio will very much depend on your investing goals and income needs.

Pros of dividend yields

Dividend yield can be a really useful metric to use when comparing companies because it is relatively easy to calculate and understand.

Clearly, dividend yield is a particularly useful metric for income investors. This group of investors – which may include retirees and others seeking to use their share portfolio as a reliable source of income – will often use dividend yield as a starting point when considering which shares to buy. These investors will prioritise shares with high dividend yields, provided the businesses are healthy and can afford to keep paying out such a high proportion of their earnings as dividends.

Dividend yield can also help with share valuation. A share's current dividend yield can be compared against its industry peers or historical average to get a sense of the relative financial health of the business. This can help you determine whether you think the company's shares are under or overvalued at the current price. 

However, it is important to reiterate that a share's dividend yield is just a starting point in any valuation exercise. It should always be considered alongside other financial and qualitative metrics and characteristics.

Cons of dividend yields

Using dividend yield in isolation can often lead to bad investment outcomes – and may even mean you might miss out on other great investment opportunities.

Some companies may appear to offer very high dividend yields, but that may only be because their share price has recently fallen. If a share seems to be offering a dividend yield that is too good to be true, it's probably because it is. Check that there haven't been any recent negative events that have caused the share price to drop, or that may threaten the safety of the dividend payout.

And always put the dividend yield in the context of a share's overall total return. If you have a longer investment time horizon and aren't currently looking to use your portfolio as an income stream, growth companies with no dividend yield may offer you a better long-term total return. Always ensure you understand how a share will help you achieve your investing and income goals before buying it.

It's not all about yield

Remember, it's not all about dividend yield. There are many other things you should also take into consideration before buying a share.

We've included some of these things below. However, this is by no means an exhaustive list. Before buying shares in a company, you should try and gain a good understanding of any additional factors that might be relevant to that particular company's business activities and industry.

Things to consider

1. Dividend growth: Just because a company has recently paid a high dividend doesn't mean it will continue to do so in future. Take a look at the company's dividend history and see if it has a proven track record of increasing earnings and upping its dividend

2. Financial strength: Does the company have a strong balance sheet, low debt and a good credit rating? As an investor, you want to know that the company can ride out any financially difficult periods without affecting your dividend

3. Dividend stability: Have a look at the company's payout ratio (or the percentage of its profits it pays out to shareholders as dividends) over time. Does the payout ratio seem sustainable? Can the company afford to continue to pay a stable dividend, or is it eating up too much of its earnings?

4. Competitive advantages: Does the company have an advantage over competitors in its industry that may help guarantee its ongoing earnings potential? Competitive advantages include things like brand recognition, proprietary technology, or cost advantages

5. Growth prospects: Is demand for the company's products and services increasing, or is it shrinking? What is the potential for the wider industry in which it operates? Companies will struggle to maintain or increase their dividend payments if their earnings potential is decreasing

6. Dividend traps: Some companies may appear to offer a high dividend yield, but it may only look high because the share price has recently plummeted. If the decline in the company's share price was triggered by poor financial performance, it could also signal that the size of the company's dividend may soon be cut. Income investors who purchased the share hoping to receive a high yield on their investment may be disappointed when their dividend payment doesn't meet their expectations.