Now that we have an understanding of what a dividend is lets look into the yield.
A yield is the dividend per share divided by the current price of the stock expressed as a percentage.
Here’s an example.
Say you own shares of DIVICENTS CORP! and they pay out a yearly dividend of $1 per year. The current price is $10.
1÷10=0.1 or 10%
This would give D.C! a current yield of 10%.
Now, as I mentioned above, a yield is the dividend per share divided by the current price of the stock, what we have to keep in mind is that the price of a stock is almost always in motion. Say that our shares of D.C! had a great year and have moved all the way up from $10 a share up to $20. Although the shares have double D.C! board of directors have decided to keep the dividend payout at a steady $1 per year.
Now lets look at the yield again. $1 divided by $20 current share price is 1÷20=0.05 or 5%. The dividend stayed the same yet the yield was cut in half.
Having a low yield is not necessarily a bad thing, nor having a high yield is necessarily a good thing. Let’s have a look at a couple scenarios.
Let’s pretend D.C! just released a press statement saying that they have won an exclusive contract to supply all the ingredients to make soap to the PAPER STREET SOAP company.
PAPERSTREET SOAP is the biggest and best soap company in the world and D.C.! is going to make a lot of money of this deal. This is a tremendous opportunity and D.C! stock just went through the roof. It’s stock is now trading at $40 per share. It’s still 2 months away from releasing it quarterly financial results so the dividend are staying at $1 until then with no guarantee of them going up. The current yield is $1÷$40=0.025 or 2.5%. Not a great yield but I would still think this is a buying opportunity with a high probability that the EARNINGS PER SHARE or EPS will increase in the next quarterly result and D.C! will increase their dividend payout!
Now scenario 2. Let’s pretend that DIVICENTS CORP! has been supplying PAPER STREET SOAP company with all it soap making material exclusively for the past 2 years. D.C! has increased its dividend every quarter for 2 years and is now paying out a pretty hefty dividend of $3 per share. Out of no where PAPER STREET SOAP company releases a press statement that they are terminating their exclusive deal with D.C! due to the fact that D.C! wasn’t selling them tallow as they had promised but instead had been supplying human fat from a Liposuction clinic! The news wreaks havoc and the shares of D.C. crash all the way down from $40 to $20. It’s still 2 months away from releasing its quarterly financial results and the dividend is still $3 but everyone on the street knows D.C. EPS are going to take a massive hit. The current yield is now sitting at $3÷$20=0.15 or a massive 15%. Although this is seemingly a fantastic yield I would not judge this to be a good buying opportunity until we have some clarity on the earnings. Seeing a 15% yield would definitely send up the red flag and could possibly result in a cut to the dividend.
A company needs to make enough money to payout the dividend!!
To understand if the dividend is in risk we have to learn about a couple more things. Earnings per share or EPS and Payout ratio.
WHAT IS EARNINGS PER SHARE?
WHAT IS A PAYOUT RATIO?