One of the reasons to invest in a particular company's stock is if it pays out dividends to its shareholders. Some businesses pay cash dividends to their stockholders on an annual or quarterly basis. These payments can occur whether or not the stock gains value. Dividend yield, which is a way of measuring a stock's dividend payment rate, can help indicate how risky an investment is. It can also pose new risks and options for investors who choose to buy.
Dividend yield is a financial ratio that indicates how valuable a stock's dividends are. Each business that elects to offer a dividend sets its own dividend rate, distributing dividend payments on a per-share basis. Dividend yield is equal to the dividends a company pays per share divided by the market price of a single share. A stock with a higher dividend yield pays out more based on the value of its shares, which means it costs an investor less to receive the same dividend as a stock with a lower yield.
Dividend yield is one of many tools that analysts and investors use to determine the value and risk of a given stock. Because companies only issue dividends with money they have available, a history of high dividend yields indicates that a business has ample cash on hand, and is at a lower risk of falling behind on its debt. It also means that the business has money to invest in expansion. These factors help stabilize and increase the value of stock, whereas a low or falling dividend yield may indicate a lack of revenue and additional financial problems. If this is the case, the stock will represent a higher risk to investors.
A stock that offers dividends presents a different type of risk to investors as well. That risk involves the chance that the company will elect to cut its dividend or eliminate it entirely. This may occur if a business runs low on available cash or if its revenues decline rapidly. Dividend cuts can be unexpected and leave investors without payments they were counting on. Faced with dividend cuts, an investor who needs cash may choose to sell shares, even if the share price is low at the time. Investors can examine a company's dividend history and earnings trends to determine how much of a risk there is that the dividend will be cut in the near future.
Stocks with high dividend yields help investors hedge against risk by giving them a means of earning investment income -- even if the stock falls in value. For example, an investor who purchases 100 shares of stock for $30 each when the stock has a dividend yield of 25 percent, starts with a principal investment of $3,000 and receives a dividend of $750 in the first year. If the stock price is at $20 per share a year later, the investor's $750 dividend payment helps offset the $1,000 loss in stock value.
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