Risk-averse investors are heavily dependent on the dividends released by the company as it is a means of steady income. Therefore, they invest in dividend stocks. A dividend is the distribution of a company’s profits to its shareholders, and is normally paid out once a year or semi-annually. Investing in dividend stocks is beneficial to such investors as it gives them two sources of potential profits:
- The predictable income from regular dividend payment by companies
- Stock price appreciation as the company grows over time.
However, blindly investing in dividend stocks might invite risks, therefore, it is necessary to first evaluate a company using the dividend yield ratio.
What is a dividend yield ratio?
The dividend yield ratio is a financial metric used to evaluate a company before purchasing its stocks. The ratio does not indicate good or bad stocks but is used to assess risks and benefits involved while investing in such stocks and to check if these meet an investor’s financial objectives.
Dividend yield ratio – how is it calculated?
The ratio is computed by dividing the dividend per share by the market price per share and multiplying the same by 100. Here is its mathematical formula,
Dividend yield ratio = Dividend offered per share / Market price per share
For instance, if a company has announced Rs 20,00,000 as a dividend to be paid to its shareholders and the total number of stocks is 10,000 then the dividend for each share will be calculated as
Dividend per share = 20,00,000/ 10,000 = 200
So, the investors shall receive Rs 200 for each share.
Now, say the market price of shares of the same company is Rs 2000 then the yield ratio is (200/ 2000) * 100 = 10 percent.
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The dividend yield ratio can determine cash flows from a company to its investors owning stocks or shares.
Why do we need a dividend yield ratio?
The ratio can determine cash flows from a company to its investors owning stocks or shares. It shows the percentage dividend receivable worth every rupee of stock purchased.
Some investors such as retirees who prefer low-risk investments depend on dividends for income. By analysing the dividend yield ratio, they can understand the financial health of a company and its investment effects on personal finances. It will also help investors to select dividend stocks that have better dividend payout records showing reliability, and delivering good returns in the future.
Is High dividend yield ratio good or bad?
In India, which has a fast-growing economy and market, companies pay fewer dividends as compared to developed markets. The average dividend yield is 1.57 percent for BSE Sensex and 1.52 percent in BSE 100 index whereas in Japan’s Nikkei 500 it is 1.87 % . Moreover, in the USA and Hong Kong the average dividend yield is 2.07 percent and 3.38 percent respectively.
The reason behind India having a low dividend ratio is companies’ objective to prioritise growth. Here, the companies retain a large part of the profit for themselves and utilise it for market expansion or research and development, hence, sharing fewer profits with the shareholders.
A company having a high dividend yield ratio means that it is sharing profits with investors. In India, usually, public sector banks and companies, MNCs in the pharma and consumer space offer a high dividend yield ratio. Investors with the dividend received can reinvest to buy more stocks and reap more benefits.
Companies with a good yield ratio indeed are good investment decisions as in the future they will give good payoffs. However, merely depending on high dividends is a sign of trouble. The company that gives out unusually high dividends means they are not keeping a substantial portion of profits as retained earnings.
Investors, here, need to be cautious since a high yield ratio can also mean a fall in stock price. A declining stock price increases the yield ratio that speaks of financial instability in a company.
Therefore, investors need to check the valuation and the consistency of dividend-paying outs of a company.
Types of dividend yield ratio
There are two types of dividend yield ratios through which the investors can anticipate getting a better understanding of the company’s dividend yield.
Forward dividend yield: A forward dividend yield is the ratio of a company’s expected dividend payout to its current stock price.
Trailing dividend yield: It is the ratio of the company’s actual dividend payments to its share price over the previous 12 months. When future dividend payments are not predictable, the trailing dividend yield can be one way to measure value.
A word for the investors
The consistency in dividend yield and strong fundamentals are some of the positive indicators for purchasing a dividend stock. However, investors should also consider macroeconomic factors such as government policies before investing.
