When you purchase shares of common stock in a corporation and your investment strategy is to maximize dividend income, you may find it beneficial to compare investments with the dividend yield ratio. Although the dividend yield ratio is only one of many analytical tools you should utilize, it can provide some insight into the likelihood of future dividend payments.
Calculating Dividend Yield
The dividend yield ratio will tell you the percentage of a stock’s market price that a corporation pays out in dividends during the year. To calculate the dividend yield ratio, divide the total dividend payments made over the course of the year on one share by the stock’s market price on the last day of the corporation’s fiscal year -- which for most companies is Dec. 31. To illustrate, suppose that shares of stock in XYZ, Inc. trades at $100 on Dec. 31. If the company makes one dividend payment during the year of $5 -- the dividend yield ratio is 5 percent.
Dividend Yield Analysis
Evaluating the strength of your investment in terms of its dividend yield has some limitations. In other words, the stock with a higher dividend yield doesn’t always mean it’s the best investment. For example, suppose you calculate the dividend yield on a second stock that also trades at $100 per share on Dec. 31, but only pays shareholders $4 in dividends during the year -- resulting in a 4-percent dividend yield ratio. Initially, you may think that purchasing the stock with a 5-percent yield is a wiser investment. But you also need to consider how volatile a stock’s price is during the year.
Using Average Stock Prices
When one or more of the stocks you are evaluating fluctuates in price during the year, you should consider using the average market price in the denominator of the dividend yield ratio. Using the average market prices will result in a more realistic or accurate dividend yield ratio. To illustrate, suppose the stock with a 5-percent yield trades at $150 per share on Jan. 1 and the 4-percent stock trades at $60. As a result, the dividend yield on the first stock decreases from 5 to 3.3 percent, whereas the second stock’s dividend yield increases from 4 to 5 percent. By using the average stock price, the dividend yield provides more information on the overall performance of a company during the year. Since the purpose of your analysis is to forecast future dividends, a significant decrease in the price of a stock can indicate that the company’s earnings are decreasing. And without earnings, a company is unable to pay any dividends.
The price-to-earnings ratio, commonly known as the P/E ratio, is widely used by investors to evaluate a company’s earnings and can also be helpful for evaluating the potential for future dividends. The ratio’s formula uses the year-end stock price as the numerator and the company’s annual earnings divided by the number of outstanding shares at the end of the year as the denominator. Generally, the lower the P/E ratio, the more likely it becomes that a company is performing well and has sufficient earnings to pay dividends.
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