JARGON BUSTER: BREAKING DOWN THE DIVIDEND YIELD
Roy Davidson, 7 May 2019
In this jargon buster we explore the concept of a dividend yield; why it is a useful measure for investors, and why a higher dividend yield is not necessarily better.
What is a dividend yield?
Dividends are the portion of a company’s profits that are paid out to shareholders. A dividend yield compares the annual dividends paid by a company to its share price. In its most commonly used form, it shows the percentage return an investor can expect to receive from dividends when investing in a company.
So if a company’s dividend per share for the year ahead is forecast to be $1, and you purchase shares in the company for $20 each, then the dividend yield would be 5%. That is to say, the return an investor can expect to receive from dividends alone is 5%.
Interpreting the dividend yield
The dividend yield informs an investor of the annual income they can expect to receive by way of dividends from their share investment. This makes for useful comparisons with the income from other investments, such as the interest rate on term deposits, or the rental yield on a property.
Of course, the other key component of the return from shares is the change in the value of the shares themselves, which tends to be more volatile.
Therefore, the overall return will be more or less than the dividend yield. As shown in the chart above, the capital proportion of the return fluctuates while the dividend return is much more stable.
It is also important to note that as dividend yields are usually based on expected dividends, the actual dividend received may turn out to be greater or smaller than anticipated, depending on how the company actually performs.
Don’t underestimate the importance of dividends
Dividends are, of course, an important contributor to returns. Since 2001, the NZX 50 capital index (this excludes dividends) has returned just over 4% per annum. Meanwhile, the NZX 50 gross index (which includes dividends that are then reinvested in the index) has returned just under 10% per annum. This clearly shows that dividends have historically made up a significant portion of returns from New Zealand shares, while also providing a valuable source of income.
Bigger is not always better
Does this mean, therefore, that we should then just invest in companies with the highest dividend yield? Not necessarily:
- A company with a high dividend yield is likely to be paying out close to, or all, of its profits to shareholders. While not necessarily a bad thing (especially for companies operating in mature industries with limited investment opportunities), this means the business has fewer funds available to reinvest into growing the business, thereby driving future dividend growth and shareholder returns.
- A high dividend yield could also be a sign that the market sees a reasonable chance that a company’s dividend is unsustainable and may need to be cut. This may be due to the company paying more in dividends than it earns, or because the operating environment is deteriorating. For example, two years ago Telstra traded on a dividend yield of over 7%, with many anticipating a cut to the dividend. This ultimately eventuated (twice) and the company now trades on a dividend yield of 5% and at a much lower price.
When we look at companies, we focus less on the current dividend yield, and more on the company’s ability to sustainably pay and grow its dividend. This includes looking at the strength of the company’s cash flow (from which dividends are ultimately paid), along with the outlook for the company and the structure of the market in which it operates.
As an example, ten years ago Ryman Healthcare paid an annual dividend of five cents per share putting it on a relatively modest dividend yield of 2.8%. However, over the last decade, Ryman has more than quadrupled its dividend to 20.4 cents per share which represents a yield on the initial investment of 11.3%.