Dividend yield refers to a stock's annual dividend payments to shareholders, expressed as a percentage of the stock's current price.
For example, Microsoft pays an annual dividend of $1.44, and the stock trades for $53.00 as of this writing. Therefore, Microsoft's dividend yield is:
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.
Calculating dividend yield from quarterly or monthly dividends
Most stocks pay quarterly dividends, and some even pay on a monthly basis. In this case, in order 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.
Dividends are one component of a stock's total rate of return, the other being changes in the share price. For example, if a stock's price goes up by 5% this year and it pays a 3% dividend yield, then your total return is 8%. If you're investing for the long term, be sure to consider a stock's total return potential in addition to the yield.
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. There are several things you should consider before investing, including (but not limited to):
- Does the company have a strong history of profit growth and dividend increases? There is a long list of companies, known as the Dividend Aristocrats, that have all increased their dividends for at least 25 consecutive years – this may be a good place to start.
- Is the company's financial position strong? Namely, does the company have a reasonably low debt load and an investment-grade credit rating?
- Is the dividend sustainable, or is the company paying out too much of its profits as dividends? Be sure to consider the "payout ratio," which is the percentage of profits that a company spends on dividends. As a rule of thumb, I like my dividend stocks to pay out no more than 50% of their earnings as dividends. Real estate investment trusts (REITs) are an exception, as they are required to pay out at least 90% of their net income to shareholders.
- Does this company have potential to grow over time? Utilities and telecom stocks tend to pay out high dividends, but they have limited growth opportunities. It's important to create an income stream that will grow.