If you’re interested in pursuing a long-term dividend strategy, understanding dividend yield could help you make investment decisions.
Let’s say you plant a tree in your yard to add beauty to your view and value to your home. And maybe you choose a tree that bears fruit to give you an epicurean delight in addition to that beauty and value.
In other words, certain trees may put a cherry on top of your landscaping investment. And that’s a little like investing in a stock that pays dividends.
A dividend is a portion of a company’s earnings paid out in cash (or stock) to shareholders on a per-share basis. Most dividends are paid in cash, and many are distributed quarterly (although some companies offer monthly dividends).
Why do some companies pay dividends? Think of dividends as incentives to reward shareholders and attract new investors. Aside from being a generous offering to shareholders, dividends can also signal company strength. (Under certain circumstances, dividends can also indicate company weakness. We’ll get into this a little later.)
A long-term dividend investor’s goal is to increase the total value of portfolio returns by accumulating dividend payments in addition to growth. But how much might a single dividend stock yield on an annual basis? What makes one dividend yield more competitive than another? What is dividend yield?
Here’s a simple dividend yield definition: The dividend yield is the ratio of a company’s annual dividend payment in relation to its stock price. In other words, dividend yield tells you what percentage of a stock’s price (per share) you may receive as a dividend payment.
To make this more clear, let’s look at how dividend yield is calculated:
Dividend yield = annual dividend ÷ stock price
Say company XYZ offers an annual dividend of $0.50 per share, and its stock is trading at $20. If you divide the annual dividend of $0.50 by the stock price of $20, you get a dividend yield of 0.025, or 2.5%.
Simple enough. But there are a few things that can make this a little tricky. For example, what if you don’t know a company’s annual dividend? All you may know is the current dividend payout rate.
One way to estimate a company’s annual dividend is to take the current dividend and multiply it by the number of periods in which dividends are paid. So if dividends are paid quarterly, then multiply the current dividend by four. If it’s paid monthly, multiply by 12. This should give you a quick estimation or projection of what a company’s annual dividend might be.
It’s important to understand that changes in a stock’s price can raise or lower dividend yield. For example:
For many dividend investors, high-paying dividends may seem attractive. They can be, but you might want to ask why a company’s dividend is high before buying the stock.
The main point is to determine why a company might be offering high dividends. Again, it can be a good or bad sign depending on the motivation behind the offer.
Because dividends are, by definition, a portion of company earnings, buying stocks can be the most direct way to receive dividends. But if you don’t want to go the direct route, you can also find exchange-traded funds (ETFs) or mutual funds that invest heavily in dividend stocks. Alternatively, Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs) can also provide high dividend yields, in some cases higher than stocks.
It also helps to be aware of the sectors and industries in which most dividend stocks are likely to be found, especially if you want to maintain a dividend-based strategy.
Don’t forget that a dividend is like a supplementary bonus to a stock’s growth. If a stock’s value declines, it will likely affect your overall returns, despite any gains you’ve made by accumulating dividend payments.
Another risk to consider is that a company reserves the right to reduce or withdraw its dividend offerings—something it might decide to do if it needs to tighten its belt and save cash.
Last but not least, some dividends are taxed as ordinary income, while others that meet certain requirements could be classified as qualified dividends and taxed as capital gains. Talk to your tax professional to see how this may impact your overall portfolio returns.
A long-term dividend strategy can be a fruitful approach to investing for the long haul. Just be aware that it’s about the quality of the dividend, not the quantity of its offering. A higher dividend yield may or may not be favorable to your investment goals and risk tolerance.
Payment of stock dividends is not guaranteed, and dividends may be discontinued. The underlying common stock is subject to market and business risks, including insolvency.
Karl Montevirgen is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
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