Dividend yield is a stock's annual dividend payments to shareholders expressed as a percentage of the stock's current price. This number tells you what you can expect in future income from a stock based on the price you could buy it for today, assuming the dividend remains unchanged.

For example, if a stock trades for \$100 per share today and the company's annualized dividend is \$5 per share, the dividend yield is 5%. The formula is annualized dividend divided by share price equals yield. In this case, \$5 divided by \$100 equals 5%.

Image source: Getty Images.

It's important to realize that a stock's dividend yield can change over time either in response to market fluctuations or as a result of dividend increases or decreases by the issuing company. So the yield is not set in stone. It's most useful as a metric to help determine if a stock trades for a good valuation, to find stocks that meet your needs for income, and to let you know that a dividend may be in trouble.

## How to calculate dividend yield from quarterly or monthly dividends

Most stocks pay quarterly dividends, some pay monthly, and a few pay semiannually or annually. To determine a stock's dividend yield, you need to annualize the dividend by multiplying the amount of a single payment by the number of payments per year -- four for stocks that pay out quarterly and 12 for monthly dividends.

If you're looking to collect dividends as often as possible, stocks that pay monthly may be ideal. Most (though not all) monthly payers are REITs, or real estate investment trusts. This category of companies benefits from some tax advantages that allow them -- actually, require them -- to pay above-average dividends.

One of the most popular is Realty Income (NYSE:O), which we can use as an example. As of November 2021, the most recent dividend was \$0.246 per share, and the share price was \$71.60. Let's use the formula in the previous section to determine the dividend yield.

A monthly dividend of \$0.246 times 12 equals an annualized dividend of \$2.95 (rounded). That \$2.95 dividend divided by a share price of \$71.60 equals a dividend yield of 4.1%.

If you're calculating a stock's yield, be careful. Don't just assume that the next dividend payment will be equal to the last. Companies occasionally issue special dividends, and dividends can also get cut. Take the time to research the company and make sure the dividend yield you think a stock will pay matches up with reality.

Data source: YCharts.

The dividend yield shown on many popular financial websites can also be misleading. These sites often report trailing dividend yields, and sometimes they still show a yield that's no longer accurate even after a company has announced a dividend cut.

## Total return

Dividends are one component of a stock's total rate of return; the other is changes in the share price. For example, if that \$100 stock described above has gone up in value \$10 after a year, you've gained 10% in appreciation, plus that 5% dividend yield, for a total return of 15%. If you're investing for the long term, be sure to consider a stock's total return potential in addition to the yield. The lesson is that, depending on your investing goals, you could be skipping the best dividend stocks if you're focusing too closely on dividend yield.

As an example, let's say that, in 2015, you bought stock in AT&T (NYSE:T) instead of Verizon Communications (NYSE:VZ) because its dividend yield was a much higher 5.4% at the time compared to Verizon's 4.6% yield.

Since then, Verizon has proven to be the superior investment, generating 51% in total returns compared to 10% in total returns for AT&T:

Data source: YCharts.

When you look past the dividend yield at the underlying business, AT&T has struggled under the weight of multiple ill-advised and expensive acquisitions, while Verizon has been a far more steady performer.

## Pros of dividend yields

Dividend yield is a useful metric when applied appropriately and the time is taken to understand if the company behind the payout is able to keep paying it. Here are a few examples of how dividend yield can be useful.

Income investors, or people looking at their investment portfolio as a source of income today, will rely on dividend yield as a starting point when considering which dividend stocks to buy. After all, if you're living off your portfolio, you have a minimum amount of income you need it to produce. If you're in this situation, you may prioritize stocks that pay the higher yield today as long as the business is doing well and its earnings and balance sheet are strong enough to keep the payout safe.

Dividend yield can also be a useful tool to help with valuation. If the dividend yield is significantly different than its historical level or is significantly different from similar companies, it can help inform whether a stock is trading for a better -- or worse -- valuation. Again, the yield is only the starting point; knowing what is happening with a company's operations and cash flows is important to help keep the dividend yield in proper context.

## Cons of dividend yields

The biggest problem with dividend yield is when investors misuse it or rely on it entirely to make their decisions about which stocks to buy and which to ignore. The example of Verizon and AT&T is a case in point. A higher yield doesn't matter if there are risks to the company that pays the dividend. AT&T struggled under billions in debt from multiple acquisitions that went badly, leading to a planned asset spinoff that will change the structure of its cash flows and lead to a huge dividend cut in 2022.

Focusing exclusively on the dividend yield leads to poor investment outcomes with underperforming companies and can also cause investors to miss out on better opportunities.

Here's another case in point. In 2010, Mastercard's (NYSE:MA) dividend yield was a paltry 0.26%, while credit card competitor American Express (NYSE:AXP) shares yielded almost 2% at the time. For some investors, AmEx's higher yield represented a "safer" investment since you could always count on that trickle of income each quarter from dividend payments. Yet, over the past 11 years, Mastercard has proven to be the far better investment with 1,350% in total returns, which is more than triple the 430% American Express has delivered.

Here's the real kicker. Mastercard's enormous growth made it one of the best dividend growth stocks over that period. It now pays a larger dividend than American Express, having grown its payout almost 30-fold:

Data source: YCharts.

The lesson here is that focusing too closely on yield can cause you to invest in struggling companies and overlook investments that could do more to boost your total wealth.

## It's not all about yield

When shopping for dividend stocks, it's important to keep in mind that a high dividend yield alone doesn't make a stock a great investment. To the contrary, a yield that seems too good to be true very well could be.

However, there are several things you should consider before buying any dividend-paying stocks, including, but not limited to:

1. Dividend growth: Does the company have a strong history of increasing earnings and then rewarding investors with regular dividend increases? A good starting point is the Dividend Aristocrats, a group of S&P 500 stocks that have increased their dividends for at least 25 consecutive years.
2. Financial strength: Does the company have a reasonable debt load based on its industry and an investment-grade credit rating? Does it have sufficient cash and working capital to ride out an unexpected change in the economy or a downturn in its industry?
3. Dividend stability: Does it have a margin of safety between how much it earns and how much it pays in dividends? The payout ratio, which is the percentage of profits that a company spends on dividends, is a useful way to measure this. This metric is best used over an extended period, not just a single quarter or even a year, and it can be augmented with the cash payout ratio since there are many non-cash expenses that can affect a company's net income going by generally accepted accounting principles (GAAP).
4. Competitive advantages: How does the company continually beat its competitors or keep them at bay? A cost advantage, the network effect, and a brand that people will pay a premium for are some examples of durable competitive advantages.
5. Growth prospects: Is the company in an industry that is growing quickly or is demand for its products or services shrinking? Even the best company in a declining industry will find it harder to maintain (much less increase) its dividend over time.
6. Dividend traps: What is the dividend yield compared to its competitors or peers? High yields aren't bad, but, in some cases, they are a sign of trouble. Certain industries tend to pay high yields, including REITs, as well as utilities, refiners, and pipeline operators that may have low growth prospects. But, if a stock's dividend yield is far higher than those of its nearest competitors, that could indicate a dividend yield trap, meaning a company whose yield looks high because the stock price has fallen and there's a good probability that the dividend payout is going to get cut.