Dividend yield explained: what it is and why it matters

What’s on this page?

1. What is dividend yield?

2. How to calculate divided yield

3. Factors affecting dividend yield

4. High vs low dividend yield stocks

5. Dividend yield strategies for investors

6. Inflation vs dividend yield

7. Dividend yield: advantages and disadvantages

What is dividend yield?

Dividend yield is the ratio of a company's annual dividend payments to its current share price. This metric is expressed as a percentage – it shows how much a company pays out in dividends each year relative to its share price. So, you can use it to estimate your return on investment (ROI). When you invest in stocks, it’s important to note that not all companies pay dividends.

A dividend yield can help you compare income potential between different stocks. It can also help you evaluate opportunities against other income-generating investments like bonds. But it’s vital to do your due diligence and manage your risk by considering other comparative aspects. These include payment characteristics (ie fixed, variable or discretionary), potential for income growth, risk profile and factors that affect price changes.

How to calculate dividend yield

Dividend yield is calculated by dividing the value of a company’s annual dividends per share by its current share price, and then multiplying the resulting figure by 100. Expressed as a formula, it’s:

If a company pays £2 in annual dividends – for example – and its current stock price is £50, the dividend yield would be 4% ([£2 ÷ £50] × 100).

Since dividends are generally paid quarterly, you’d multiply the most recent payment by four to get the annual dividend amount to use in the calculation. It’s also important to note that some companies pay special one-time dividends, which shouldn't be included in the regular dividend yield calculation.

Dividend yield example

Suppose Company ABC’s stock price is £40 per share and its quarterly dividend is £0.50 per share.

Here’s how you’d determine what the dividend yield is:

Step 1: calculate annual dividend

Quarterly dividend × 4 quarters
£0.50 x 4
Annual dividend = £2 per share

Step 2: calculate dividend yield

(Annual dividend ÷ stock price) × 100%
(£2 ÷ £40) × 100%
Dividend yield = 5%

Dividend yield is affected by changes in both dividend payments and stock price movements. Here are some examples of how dividend yield can change based on certain changes in Company ABC’s figures:

• If the stock price drops to £32, for example, the dividend yield would be 6.25%. The yield increases as the stock price decreases

• Say the stock price rises to £50 instead. The dividend yield would be 4%. The yield decreases as the stock price increases

• If the company raises its quarterly dividend to £0.60, the annual dividend would be £2.40, and the dividend yield would be 6%. The yield increases as the dividend amount increases

Factors affecting dividend yield

• Stock price changes

• Dividend payment changes

• Company lifecycle stage

Stock price changes

When a stock’s price goes up, dividend yield decreases, and vice versa. Factors that move a stock’s price determine demand for buying and holding a stock through market sentiment and investor confidence. These factors include:

• Company performance, eg earnings consistency, revenue growth, profit margins, debt obligations and ROI

• Management credibility

• Future growth expectations

• Innovation potential and industry trends

• Market position and brand strength

• Market conditions

• News and announcements that affect the company

Dividend payment changes

Increases in dividend payments raise the yield, whereas dividend cuts lower the yield. Dividend payouts depend on several aspects, including the below.

• Business performance: eg earnings, cash flow and operating costs

• Strategic decisions: mergers and acquisitions (M&As), business plan changes, share buyback programs and more

• Dividend policy: eg perspectives of the company’s board and executives, growth opportunities and long-term sustainability goals

Company lifecycle stage

Compared to start-ups, growth companies and businesses in the decline stage, mature companies typically offer higher dividends and they offer them more consistently.

• Startups usually don’t pay dividends. They focus on product development and establishing market presence

• Growth companies often pay lower dividends, or none at all, as they tend to reinvest profits towards building on operational capacity and expansion

• Companies in the decline stage of the business lifecycle are generally more focused on revival and maintaining market position. Dividends of such companies are often paid irregularly, with less predictable amount fluctuations

Other factors that affect dividend yield include changes in tax rates, interest rates, inflation and economic cycle stages (eg recession, recovery and expansion).

High vs low dividend yield stocks

Whether dividend yield is high or low isn’t necessarily enough to make investment decisions, as dividends are typically paid by stocks with larger market caps. There are other technical and fundamental analysis factors that can give you a more comprehensive view of a stock’s performance.

When taking dividend yield into account, a higher percentage isn’t necessarily better, as it could indicate a falling stock price or an unsustainable payout. A very high dividend yield (ie above 7%) may signal that investors expect the dividend to be cut. On the other hand, companies with low dividend yields may offer value through stock price appreciation instead.

Dividend yield strategies for investors

• Income-focused strategy

• Dividend growth strategy

• Total return strategy

• Risk management strategy

Income-focused strategy

The income-focused strategy targets mature companies with a strong market position and a stable earning history. It aims for consistent dividend payments by diversifying across defensive sectors such as utilities, healthcare and consumer staples. To be prioritised as a dividend recipients, you can buy preferred stocks instead of common stock, but a mix of these can also be used in employing this strategy.

Dividend growth strategy

The dividend growth strategy focuses on companies with a history of dividend increases, like dividend aristocrats, ie stocks with 25+ years of increases. Other common aspects to consider for this strategy include a current yield that’s moderate, ie 2 to 4%, revenue growth trends and competitive advantages.

Total return strategy

The total return strategy balances dividend yield with capital appreciation potential. It’s used to diversify across different sectors and dividend yield levels for exposure to both mature and growing companies. Some of the metrics that can be useful in finding such stocks include price-to-earnings (P/E) ratio and price-to-book (P/B) ratio.

Risk management strategy

This strategy focuses on mitigating risks through methods such as:

• Analysing dividend coverage ratios

• Monitoring industry and economic cycles

• Diversifying across sectors and regions

• Identifying unsustainably high yields

• Reviewing company fundamentals regularly

• Considering economic moats with competitive market positions

• Monitoring changes in companies’ business models

Inflation and dividend yield

Companies may adjust dividends to maintain real returns, as inflation reduces purchasing power. Companies can respond to inflation to try maintain purchasing power. But increasing dividends to maintain real returns doesn’t come without challenges – to raise dividend amounts, companies need the funds to do so. This requires strategies around pricing power, cost pressures, cash flow and working capital.

Certain sectors generally handle the effects of inflation relatively well. These include:

• Utilities – via regulated price increases

• Consumer staples – through pricing power

• Natural resources – via commodity price correlation

• Infrastructure – through inflation-linked revenues

Here are some other ways in which you can manage dividend investments during inflationary periods:

• Focusing on companies with dividend growth above inflation

• Looking for businesses with pricing power

• Monitoring payout ratios for sustainability

• Evaluating companies’ cost structures and margins

• Balancing between current yield and growth potential

• Regular portfolio rebalancing to maintain purchasing power

Dividend yield: advantages and disadvantages

Below are some of the key advantages and disadvantages of dividend yield.*

Advantages of dividend yield

• Regular income stream

• Potential for income and capital growth

• Can reinvest dividends for compounding effect

• Dividend-paying stocks are generally less volatile

Disadvantages of dividend yield

• Dividends may be taxed as ordinary income

• Cuts in dividend payouts can impact income

• Interest rate sensitivity

• Affected by economic cycles

FAQs

Try these next

Learn how to get exposure to shares via trading or investing with us.

Explore the platform types we have available for you to choose from.

Find out what the differences are between trading and investing.