For companies that pay regular dividends, dividend yield is a useful evaluation tool. Dividend yield represents how much a company pays out in dividends annually relative to its share price. It is displayed as a percentage that you can calculate by the dividing the dollar value of dividends paid by the dollar value of one share of stock.
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The formula for calculating dividend yield is:
Dividend Yield = Annual Dividends per share/Price per share.
Example: Company A stock currently trades for $20. Company A pays $1 per year in dividends. The dividend yield would be $1/$20 or 5%. Company B trades for $40 and pays $1 in dividends annually. Company B’s dividend yield would be $1/$40 or 2.5%.
Choosing Stocks Based On Dividend Yield
Since dividend yield essentially equals the amount of cash flow (return) you are getting for each dollar invested, Company A represents the best investment – assuming all other factors are equal. Of course, those other factors are rarely equal.
If, for example, capital gains for Company B were much higher than those for Company A, you might relinquish dividend yield in favor of capital gains and the opportunity to make more money through capital gains yield. (Yes, it exists and represents a separate way to evaluate an investment.)
Where The Money Goes
If you require a minimum cash flow stream from your investments – say in retirement – you would be likely to invest in stocks that have a high dividend yield. You would do so knowing full well that dividends can come at the expense of growth. Simply put, every dollar a company pays out in dividends is not reinvested in the company to secure capital gains growth.
Another way of looking at it is that by sharing the profits through dividends, the company is not using that money to build new factories (or stores) or otherwise trying to gain market share and make more profit in the long run. Ideally, of course, if a company is well-run balance can be found between dividends paid out and reinvestment for growth so that both masters can be served.
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Your investing goals help determine which tools of fundamental analysis will work for you. For example, if you are looking for high-growth technology stocks, dividend paying characteristics are not all that important. If you are a value investor or someone looking for dividend income, dividend yield becomes a very important factor.
Just because a company is currently paying a high dividend doesn’t mean that will always be the case. Older, more well-established companies tend to pay higher dividends and the history of those dividend payments tend to be more consistent. Among stocks in that arena considered to be good dividend buys for 2018, Exxon Mobil Corp. (NYSE:XOMC), Target (NYSE:TGTB), Emerson Electric (NYSE:EMRC), International Business Machines (NYSE:IBMC) and Procter & Gamble (NYSE:PGC).