Dividend yield ratio definition
/What is the Dividend Yield Ratio?
The dividend yield ratio shows the proportion of dividends that a company pays out in comparison to the market price of its stock. Thus, the dividend yield ratio is the return on investment to an investor if the investor were to have bought the stock at the market price on the measurement date. The ratio is used by investors to understand the extent to which a business has committed to pay dividends.
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Calculation of the Dividend Yield Ratio
To calculate the ratio, divide the annual dividends paid per share of stock by the market price of the stock at the end of the measurement period. Since the market price of the stock is measured on a single date, and that measurement may not be representative of the stock price over the measurement period, consider using an average stock price instead. The basic calculation is:
Annual dividends paid per share ÷ Market price of the stock = Dividend yield ratio
The outcome is expressed as a percentage.
Example of the Dividend Yield Ratio
ABC Company pays dividends of $4.50 and $5.50 per share to its investors in the current fiscal year. At the end of the fiscal year, the market price of its stock is $80.00. Its dividend yield ratio is:
$10 Dividends paid ÷ $80 Share price
= 12.5% Dividend yield ratio
Problems with the Dividend Yield Ratio
There are several problems with the dividend yield ratio, which are as follows:
Ignores capital gains. The dividend yield focuses only on cash dividends and overlooks potential capital gains from stock price appreciation. Investors who prioritize total return may find this ratio misleading as it does not capture the complete investment performance.
Industry differences. Dividend yields can vary significantly between industries, making it challenging to compare companies across different sectors. High-yield stocks might seem attractive but could signal limited growth opportunities, while low yields could indicate reinvestment for growth.
Unreliable indicator of financial health. A high dividend yield might result from a declining stock price due to financial distress, not strong dividend payments. This situation can mislead investors into perceiving a company as financially healthy when it is actually struggling.
Does not reflect earnings stability. The ratio does not consider whether dividends are sustainable based on the company’s earnings. High dividends funded by borrowing or unsustainable earnings can mislead investors about a company’s financial strength.
Impact of payout policy changes. Companies can alter their dividend policies, causing sudden changes in the dividend yield. Such adjustments can mislead investors about a company’s long-term profitability and reliability if not analyzed alongside earnings and payout ratios.