Why Yield Is Important When Looking for Income-Producing Stock Investments
Because income stocks pay out dividends — income — to their investors you need to assess which stocks can give you the highest income. The main thing to look for is yield, which is the percentage rate of return paid on a stock in the form of dividends.
Looking at a stock’s dividend yield is the quickest way to find out how much money you’ll earn versus other dividend-paying stocks (or even other investments, such as a bank account). Dividend yield is calculated in the following way:
Dividend yield = Dividend income ÷ Stock investment
|Investment||Type||Investment Amount||Annual Investment Income (Dividend)||Yield (Annual Investment Income ÷ Investment Amount)|
|Smith Co.||Common stock||$20 per share||$1.00 per share||5%|
|Jones Co.||Common stock||$30 per share||$1.50 per share||5%|
|Wilson Bank||Savings account||$1,000 deposit||$40 (interest)||4%|
Don’t stop scrutinizing stocks after you acquire them. You may make a great choice that gives you a great dividend, but that doesn’t mean the stock will stay that way indefinitely. Monitor the company’s progress for as long as it’s in your portfolio by using resources such as Bloomberg and MarketWatch.
Changes in yield
Most people have no problem understanding yield when it comes to bank accounts. If your bank certificate of deposit (CD) has an annual yield of 3.5 percent, you can easily figure out that if you deposit $1,000 in that account, a year later you’ll have $1,035 (slightly more if you include compounding). The CD’s market value in this example is the same as the deposit amount — $1,000.
When you see a stock listed in the financial pages, the dividend yield is provided, along with the stock’s price and annual dividend. The dividend yield in the financial pages is always calculated as if you bought the stock on that given day. Just keep in mind that based on supply and demand, stock prices change every business day that the market’s open, so the yield changes daily as well.
Keep the following two things in mind when examining yield:
The yield listed in the financial pages may not represent the yield you’re receiving. What if you bought stock in Smith Co. a month ago at $20 per share? With an annual dividend of $1, you know your yield is 5 percent. But what if today Smith Co. is selling for $40 per share? If you look in the financial pages, the yield quoted is 2.5 percent.
You’re still getting 5 percent because you bought the stock at $20 rather than the current $40 price; the quoted yield is for investors who purchase Smith Co. today. They pay $40 and get the $1 dividend, and they’re locked into the current yield of 2.5 percent. Even though the dividend hasn’t changed, the yield has changed dramatically because of the stock price change.
Stock price affects how good of an investment the stock may be. Another way to look at yield is by looking at the investment amount. Using Smith Co. as the example, the investor who bought, say, 100 shares of Smith Co. when they were $20 per share only paid $2,000 (100 shares × $20).
If the same stock is purchased later at $40 per share, the total investment amount is $4,000 (100 shares × $40). In either case, the investor gets a total dividend income of $100 (100 shares × $1 dividend per share).
Comparison of yield between different stocks
All things being equal, choosing Smith Co. or Jones Co. is a coin toss. It’s looking at your situation and each company’s fundamentals and prospects that will sway you.
What if Smith Co. is an auto stock and Jones Co. is a utility serving the Las Vegas metro area? In 2008, the automotive industry struggled tremendously, but utilities were generally in much better shape. In that scenario, Smith Co.’s dividend is in jeopardy, whereas Jones Co.’s dividend is more secure.
Another issue is the payout ratio. Therefore, companies whose dividends have the same yield may still have different risks.