The Dividend Yield is a key metric for those investors interested in generating cash flow from their portfolio. However, it is not the only thing that matters. We analyze what the dividend yield and how it interacts with other important metrics.
Content
Introduction
Investors who primarily seek to generate cash flow from their investment portfolio pay a lot of attention to dividends. There are several metrics used to analyze dividend-paying stocks, one of them being the dividend yield.
The dividend yield is easy to calculate and understand. It is the dividend paid by a stock over the course of a years divided by its price. Let us use JP Morgan as an example.
As of January 27th, 2023, JP Morgan’s stock price was $140.32. Over the previous 12 months, JP Morgan had paid a total of $4 in dividends. JP Morgan’s dividend yield is the dividend paid divided by the share price:
Dividend Yield = Annual Dividends / Share price
2.85% = $4.00 / $140.32
Most US companies pay quarterly dividends. European and Asian companies usually pay dividends once a year. Either way, we will consider all dividends paid over the last year.
Forward Dividend Yield
So far, we have calculated the dividend yield looking at dividends paid in the past. However, if we buy a stock today, we will no longer receive such dividends. For this reason, many investors prefer to look at the forward dividend yield, also known as projected dividend yield, if available.
The forward dividend yield is calculated using dividends expected to be paid over the next 12 months. As you can see, this metric has some advantages, since these dividends are expected to be collected by investors buying the stock today.
If we stick to JP Morgan as an example, we will see that analysts expect dividends to total $4.20 over the following 12 months. This is slightly higher than what the company paid over the previous 12 months. Consequently, its forward dividend yield will be a bit hither:
Forward Dividend Yield = Projected Annual Dividends / Share Price
3.00% = $4.20 / $140.32
What exactly are Dividends?
If you are wondering why I am addressing this obvious question is because investing mainly for dividends can be a dangerous at times. In general, dividends are that part of the profits that the company, instead of reinvesting, decides to distribute to its shareholders. And I say in general because this is not always the case.
Understanding this is key to make sure we can address the sustainability of the dividends paid by a company. While higher dividends are generally a good thing, those dividends need to be sustainable.
If a company is paying high dividends simply because it is liquidating assets, either productive or not, we need to consider that selling assets is not part of the normal business operation of the company. Therefore, dividends would have to be cut at some point in the future.
Dividend Payout Ratio
In most cases, companies finance the payment of dividends with the profits they generate. Let us look at Nestlé as an example.
In 2019, Nestlé had a profit of CHF 12.724 billion. It was decided it would allocate CHF 7.795 billion to the payment of dividends. With these data we can calculate Nestlé’s dividend payout ratio, which is the percentage of profits that are paid out to shareholders in the form of dividends:
- Dividend Payout Ratio = Annual Dividends / Annual Profit = 7,795 / 12,724 = 62%
Interestingly, the dividend payout ratio can also be calculated using the dividends per share and the earnings per share:
- Dividend Payout Ratio = Dividends per Share / Earnings per Share = 2.70 / 4.30 = 61% (difference due to rounding)
This means that 62% of the profits went to finance dividends. 38% of the profit was retained by the company to be reinvested. The fact that 62% of profits are distributed to shareholders means that the company does not see many attractive opportunities to expand and grow the business to justify keeping that money.
Therefore, looking at the dividend payout ratio is also useful to understand the growth opportunities that a company has. After all, the higher the growth, the more likely it is that the share price will rise in the future.
A ratio of 0%, which means that the company does not pay any dividends, usually goes hand in hand with a growing company, such as Amazon. Some growth companies do not have any profit but expect to do so in the future.
A low dividend payout ratio, below 40%, would indicate that the company still has plenty of room for expansion. In the case of Apple, the ratio hovers around 25%.
Ratios between 40% and 70% are usually common in mature companies with less opportunities to grow. Many of these companies enjoy very strong positions in the marketplace and are recognized brands. Therefore, they have stable benefits with low growth
There are also companies with dividend payout ratios above 70%. Imagine an extreme situation where the ratio is actually 100%. This means that all profits go to dividend payments. This is a dangerous situation and a sign of short-term thinking. This is because the company is losing capital, unable to cover the depreciation of its assets with a portion of its profit.
Finally, we should investigate whenever we see that the ratio is above 100%. This means that the company is either selling assets or using its cash reserves to pay dividends, which is most case worrisome, or, even worse, borrowing money to make those payments, which would be extremely dangerous.
If we see that take place, it is usually safe to assume that dividends will be cut in the near future. Consequently, the dividend yield of such a company can be completely disregarded.
Conclusion
Collecting dividends is one of the great perks that comes with investing. But the important thing is that those dividends are the consequence of strong and solid profits. At the end of the day, the payment of dividends itself does not create any value for the shareholders. Value comes from profits and growth.
If we want to raise some cash from a good stock that does not pay dividends, we just have to sell some shares. This is not much different than receiving dividends.
In fact, in many cases, the dividend payment itself destroys shareholder value if taxes have to be paid. This is because when a dividend is paid, the share price falls by exactly the same amount, but the shareholder has to pay taxes on the dividend. Let us look at a basic example to understand what happens:
- Before the dividend: the stock trades at $100 and tomorrow it will pay a dividend of $5. The shareholder has, therefore, a stock worth $100.
- After the dividend: the share is now trading at $95. The shareholder had to pay 20% tax on the dividend, equivalent to $1. The shareholder now has a stock worth $95 and $4 in cash. The net result is that a net loss of $1 has occurred.
If we want to raise some cash from a good stock that does not pay dividends, we just have to sell some shares. This is not much different than receiving dividends.
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