Dividend stocks are attractive to investors because they offer a steady income stream. Dividends are a portion of a company's earnings that are paid out to shareholders. Not all stocks pay dividends, but investors who hold dividend stocks have the potential not only to sell their shares at a profit, but also to collect regular (usually quarterly) payments while they still own those stocks.
But how do you measure how generous a company's payout is? One good way is to apply the dividend yield formula. The dividend yield formula is a calculation that shows how much a company pays in annual dividends relative to its stock price. The equation involves taking a stock's total annual dividend payment, dividing that by its current share price, and multiplying that figure by 100.
Dividend yield = annual dividend / current share price x 100
As an example, let's say a company pays a quarterly dividend of $0.40 per share (or $1.60 annually), and its stock price is $30 per share. Its dividend yield would be 5% ($1.50/$30 x 100).
Importance of the dividend yield formula
Not all dividend stocks are created equal, and just because one stock pays a larger dividend than another doesn't mean it's a better investment -- especially if that stock's share price is higher. Fortunately, the dividend yield formula allows you to measure how much cash flow you're getting for every dollar you put into a particular stock.
For example, if Company A pays a dividend of $2 per year, and its share price is $100, then its dividend yield is 2%. Meanwhile, if Company B pays just $1 per year, but its share price is a much lower $25, then its dividend yield is 4%. In other words, Company B pays shareholders twice as much dividend money for every dollar they invest.
Limitations of the dividend yield formula
While the dividend yield formula can help you determine whether a particular stock is a good buy, keep in mind that dividends are only one way to make money from stocks. Investors can also profit from stocks by waiting for share prices to increase and then selling at a gain. When a company pays its investors dividends, it is giving away a portion of its earnings, rather than retaining that money to grow the business. Therefore, while dividends are a good thing for those who rely on the income stream, they can also impede a stock's growth. If you invest in a stock that pays relatively high dividends, be aware that it may impact your ability to sell your shares at a gain.
Dividend yields and the payout ratio
Another thing to keep in mind about dividends is that they aren't guaranteed. A company that's currently paying dividends can lower its payments or stop making those payments altogether in the future. If your goal is to secure a steady stream of income via dividend payments, then it's important to look at not only the dividend yield, but also the payout ratio.
The payout ratio is the percentage of earnings that a company pays out to shareholders. It's often used to measure the sustainability of a company's dividend payments. If a company has a low payout ratio (often considered 50% or less, though it varies by industry), then it has more than enough earnings to cover its dividend. As an investor, you should be wary of high payout ratios, which can signal that the dividend is vulnerable to being reduced or even canceled. If a company's payout ratio exceeds 100%, then it means the company's dividend payments are surpassing its net income. That makes the dividend unsustainable -- and thus likely to be cut.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!