Ratio Analysis: The Dividend Yield Ratio

If you’re an income investor or a believer in compounding, the dividend yield ratio will be an important consideration when investing. It’s the third of four valuation ratios profiled by Axel Tracy in his 2012 book, "Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet."

The dividend yield is a ratio because it is one thing in relation to another. It is the dollar value of a dividend in relation to the price of its stock.

It is well known and frequently used because it can be compared against itself and against other asset classes. As Tracy observed, “This is because most investment returns are expressed as some sort of yield or percentage on investment, whether it is property, bonds, bank savings, etc. What the Dividend Yield does is turn the return on an investment in the stock market into a yield that can be compared against every other alternative investment.”

While those who invest for capital gains or capital appreciation may be less interested, the author noted that “many finance academics believe that dividends are the only ‘true’ return on a stock market investment.” Those academics start with the ‘efficient market hypothesis’ or the ‘random walk’ theory; from that, they presume that capital growth is a matter of chance and every stock may gain or decline.

That rejection of consistent capital appreciation leads to the belief that dividends are the “only ‘true’ returns that can be predicted and valued.” Of course, we know many investors reject that view, having seen examples of investors, both professional and amateur, consistently and predictably outperform the market. At the same time, a lot of investors fail to capture that appreciation because of practices such as jumping in and out of investments.

The formula for the dividend yield is:

Dividend Yield = Annual Dividends per Share / Stock Price

For example, if the annual dividend is $1 and the stock price is $8 per share, the dividend yield is 12.5% (1 / 8 = 0.125).

Both the annual dividend and the stock price are widely available, with the former also available in the Statement of Cash Flows and Statement of Stockholders’ Equity.

At GuruFocus, the dividend yield is one of several related items under the Dividend & Buyback section of the Summary page. Here’s what it looks like for Emerson Electric (EMR, Financial):

It’s worth noting that share buybacks are a form of dividend. A share repurchase plan is a non-cash dividend. Rather than getting cash, the value of an investors’ shares should increase according to the size of the buyout; for example, if a company buys back 5% of its outstanding common shares and cancels them, we would expect the value of the remaining shares to increase by about 5%.

The bars to the right of the dividend yield name indicate how the company's yield compares to the average for its industry and its own history (green color being favorable and red color being unfavorable).

The dividend yield expresses what holding the stock is currently worth to an investor without selling it. For example, a yield of 5.4% means that the dollar value of the dividend is 5.4% of the company’s stock price. From another perspective, if you buy the stock today, you would expect a dividend worth 5.4% of what you paid.

Although dividend payments tend to be quite stable, the yield may flutter up and down, as illustrated by the graph of Emerson’s dividend yield over roughly three decades:

Why is there so much variation in the yield? Tracy explained, “There are three arithmetic reasons why the Dividend Yield will change; either the stock price changes, profit changes with a static payout ratio and stock price or, on the other hand, profits and the price remain static while the payout ratio changes.”

In my view, dividend payments tend to be relatively stable for most large companies that pay them, but stock prices can bounce up and down, regardless of what may be happening with their operations.

Tracy went on to note that the dividend yield ratio is determined by management and the board of directors. Among the factors that might affect these decisions are a push by activist shareholders or the belief that a higher dividend might push up the share price by making the stock more attractive.

A management decision to lower dividend payouts also may be made for multiple reasons. One of the most obvious reasons is that the company has suffered a setback of some kind and cannot afford to keep dividends at their existing level. Another is that the company may see a high-return growth opportunity and wants to reinvest more (by cutting back dividends). Tracy wrote, “For example, if management paid lower dividends, kept the cash to grow the business and achieved a return on equity of 20% and saw a 15% increase in the stock price, then this for many is better than receiving a dividend and putting it in the bank that will return 3%.”

Three important drawbacks to the ratio were listed by Tracy. First, the dividend yield is relevant only for income investors; those with other priorities, such as capital gains, will get little value from the dividend yield.

Second, he noted:

"Further, two professors from the 1950s, Modigliani and Miller, won the 1985 Nobel Prize in Economics for developing a theory that (in part) stated that dividends have no impact on a company’s value whatsoever. Dividend payouts could be ‘chosen’ by individual investors, as they are free to reinvest their dividends in company stock and thus reduce their own dividends or, on the other hand, sell company stock in the market, receive cash for this, and create (increase) their own dividends."

Third, and finally, Tracy noted that the dividend yield can be misleading about total returns. He used the example of an investor who buys a stock based on a "fantastic" dividend yield of 7%, only to find that the stock price is declining by 20% a year. What seemed like an excellent investment is actually anything but.

On a personal note, I made that mistake myself in my early investing years, because I failed to realize, as Tracy noted, “Perversely, the faster a stock price is falling, the more appealing the Dividend Yield becomes as the ‘fixed’ dividend grows in relation to a falling stock price.”

Conclusion

The dividend yield ratio is a helpful tool for income investors who want to compare cash income from various companies. It tells them how much they will earn in relation to what they must pay to acquire the stock.

Its great value is that it enables investors to compare the returns from stocks to other asset classes, such as real estate, bonds or some other vehicle.

However, there are drawbacks to the dividend yield ratio as well, including the fact that a high dividend yield may mask problems that lead to lower stock prices.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

Read more here:

• Ratio Analysis: The Price-Earnings Ratio
• Ratio Analysis: Earnings Per Share
• Ratio Analysis: Efficiency Ratios and Cash Flow

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