The two most obvious ways of making money from a stock are selling it for more than you paid for it and getting regular dividend payments. While not all companies pay dividends (often for good reasons, such as investing profits back in the business), dividends can be attractive.
Why Would You Want Dividends?
A dividend is a portion of the earnings of the company paid to every shareholder. As an owner of the company, you're entitled to its profits.
Mature businesses—businesses with reliable earnings—can afford to pay dividends because they produce reliable profits. While not every business which pays dividends is great and not every great business pays dividends, there's a correlation between successful businesses and reliable dividend payments. Generally this means some amount of money sent to stockholders of record every quarter.
One benefit of quarterly dividend payments is that you get paid as long as you hold the stock. Unlike the unrealized gains of stock price appreciation, that's profit in your bank account every three months, regardless of the price of the stock. Of course, being that a dividend is a payout on your investment, you probably have to pay taxes on those dividends.
If you don't need the recurring dividend income, dividend reinvesting is a great way to roll your profits back into good companies to increase the amount of stock you own. This makes sense... sometimes.
Part of the process is identifying good companies. Good businesses make good stocks. Buy a great stock at a good price and you'll make money. This value investing advice which investors such as Benjamin Graham, Charlie Munger, and Warren Buffett well. That's step one.
Step two is to find some way to compare the dividend-producing ability of one potential stock against another. For that, you need a simple ratio.
Dividend Yield Compares the Payout of Similar Stocks
The dividend yield is a ratio of the annual amount of dividends paid per share divided by the current price of a stock. If a stock costs $10 per share and pays $0.25 in dividends every quarter, that's $0.25 times 4 quarters divided by $10, or $1 divided by $10 or a 10% dividend yield.
In other words, you'll get a 10% return on your investment from dividends alone if you buy that stock at $10 and it continues its $0.25 quarterly payout. That's a good rate of return!
Flip the dividend yield ratio to learn something even more interesting. In this example, the market is willing to pay $10 right now to get $1 in dividends over the next year. That's similar to the P/E Ratio, but it focuses on what the stock is likely to pay out. This number can reveal a wealth of further questions. If the dividend yield is low, why? Is the company really stable? Are investors looking for something rock solid, and willing to forego dividends to get it? Alternately, is the company growing fast and sinking all of its profit into expansion? In that case, investors might be expecting the stock's price to rise, in which case the appreciation of the stock is its own reward.
The dividend yield ratio changes with the price, so sometimes you'll see dramatic fluctuations. Look for external events. For example, perhaps the dividend has already been announced or perhaps the company has reliable quarterly dividend payments. If the ratio changes and stays changed, something in the business has changed. Pay attention.
Remember that dividend yield is a specific type of yield. It's not the only thing you should chase, but it's a good number to understand.
What is a Good Dividend Yield?
A dividend yield of 10% is fantastic—and an unrealistic example used here to make the math easy to understand.
The normal S&P 500 index dividend yield is somewhere around 2% (for companies which pay dividends). That's not a huge amount. You won't get rich from a 2% return. Anything between 2-3% is pretty normal.
Of course, the dividend yield of a stock you already own depends on the price you paid for the stock. If, as one of the writers on this site did, you paid $3.73 per share of Cypress Semiconductor a few years ago, the $0.44 it pays annually has a personal dividend yield of 11.8%, instead of the current dividend yield of 3%. (Said writer is still long on CY.)
A good dividend yield is whatever helps you meet your financial goals. In practice, however, a ratio for a stock you're considering anywhere between 3% and 5% is worth noting. More than that, and something's fishy. Less than that, and dividends may not be worth examining more fully.
Using the Dividend-Price Ratio to Pick Great Stocks
A strong business with a high dividend ratio may be undervalued. This could represent a good opportunity to buy a stock that returns profit to its investors every quarter. Similarly a business with a very low dividend yield may be overvalued. You have to be careful, though. Do your research. What's the company's history of paying dividends? What's its history of generating free cash?
A struggling company may choose to raise its dividend in order to attract more investors to prop up its share price. This is a risky strategy. If you understand the underlying financial state of a business, you can reduce your risk of buying a messy stock.
Then again, a struggling company may currently pay no dividend, but turn things around and start paying out big in the future. For example, if you bought a company at $2.00 per share and it ends up paying $0.20 per share annually in a couple of years, you'll have achieved an effective 10% dividend yield even if the price goes to $20 or $200 per share.
Similarly, a company that's seen a lot of positive press may have a wonderful dividend yield... when the stock price returns to a more normal valuation. Because this ratio takes into account the daily fluctuations of the stock's price, you can (and should) check against prices in the recent past to see if things are getting out of control.
In the final estimation, dividends are one way you can earn money from owning a stock. They can be a good way to do so, and they're something to keep in mind, but they're not the only measure of a goodness of a business.
Chasing higher dividends may lead you to riskier stocks. Remember to look at the health of the underlying business. There's little value in getting a 5% yield on paper if the company starts losing money next year. Yet even so, healthy companies which pay dividends can help you achieve your goals from investing in the stock market.
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