What is Dividend Yield in Stock Market?

Investing in dividend-paying stocks is one of the many ways to create a passive income source. In the Indian stock market, there’s no dearth of fundamentally stable companies that offer regular dividends. However, not all dividend-paying companies are the same. 

For example, some may offer high dividends once a year, whereas others may offer lower dividends more frequently. So then, how do you determine which stock is the better option for you? 

Simple, using the concept of dividend yield. Wondering what it is? Here’s a detailed overview of the concept, the formula used to calculate dividend yield and its various advantages and disadvantages. 

What is Dividend Yield? 

Dividend yield is a crucial financial metric that many long-term investors use to determine the attractiveness of a stock. The metric is represented as a percentage and gives you an idea of just how much dividend a company is paying relative to its current market price. The higher the dividend yield is, the better a company is usually deemed to be. 

Calculating the dividend yield of a stock is very simple. All you need to do is use the following mathematical formula. 

By using this formula, you can quickly determine the percentage of the current market price a company is paying as a dividend to its shareholders. 

Calculating the Dividend Yield of a Stock 

Now that you’re aware of the meaning of dividend yield and the formula that investors use to calculate the metric, let’s take the help of a hypothetical example to better understand the concept. 

Assume that you wish to calculate the dividend yield for a company - ABC Limited. The company recently declared a dividend of Rs. 25 per share. The current market price of the stock, meanwhile, is Rs. 2,150 per share. You can get the dividend yield for this stock by simply substituting these two values in the formula mentioned above. 

Div. Yield = (Rs. 25 ÷ Rs. 2,150) * 100 = 1.16% 

As you can see, the company has distributed about 1.16% of its current market value as dividends to its shareholders.

Understanding Dividend Yield 

Merely calculating the dividend yield for a stock may not always give you the full picture. Take the above scenario for example. You found out that the yield of ABC Limited is 1.16%; the figure on its own doesn’t tell you if it is low or high for a company of its stature. Here’s where comparing the metric with the industry average can help. 

When you compare the dividend yield of a stock with its peers or the industry, you can get key insights that can help you determine whether it is high, low or in line with the standard. Let’s say that the average dividend yield of the industry in which ABC Limited is operating is 2%. Now, comparing both figures, it is quite clear that the yield of ABC Limited is lower than the industry average, making it a less-than-ideal investment option.  

However, if the average yield of the industry was just 1% and the yield of ABC Limited as you found out is 1.16%, the scenario changes. The stock now becomes more favourable to invest in since its yield is more than the industry average. 

The Advantages of High Dividend Yield 

There are many advantages of investing in a company with a high dividend yield. As an investor, you need to know what they are. Here’s a quick overview of some of the key benefits. 

• Passive Income 

A high dividend yield means higher passive income through dividends. If you’re seeking regular cash flow from  your investments, investing in a high-dividend yield company may be the way to go. 

• Better Business Stability 

Only companies with strong businesses and exceptional financial stability offer consistently regular dividends at high yields. This can be reassuring if you’re looking for value and stability in your portfolio.

• Hedge Against Inflation 

As a company with a high dividend yield grows and increases its profits, it is likely to also raise the amount of dividends. This increase in passive income over time can help you overcome the effect of inflation. 

The Disadvantages of High Dividend Yield 

As an investor, you shouldn’t just focus on the advantages of investing in high-dividend yield companies. In fact, you should be more aware of its disadvantages. Let’s take a glimpse at some of the key drawbacks of high dividend yields. 

• Lower Potential for Capital Appreciation

A company with a high dividend yield generally distributes a major portion of its profits to its shareholders. This generally reduces the profits available for reinvestment into the business, which can limit future growth and consequently capital appreciation potential. 

• Lack of a Full Picture 

A company’s dividend yield may look more attractive than it really is even if it doesn’t raise its dividends. This can happen if the dividends are stable but the stock price declines rapidly. Such artificial inflation can potentially mislead you into thinking that the company is a better investment option than it actually is.  

• Tax Implications 

Dividends are added to your total income and are taxed at the income tax slab rate applicable to you. The more the dividend income, the greater your tax liability is likely to be, which can ultimately reduce the yield even further. 

Comparison Between Dividend Yield and Dividend Payout Ratio 

Apart from dividend yield, there’s another very crucial financial metric that provides insights into a company’s dividend payment ability - the dividend payout ratio. Understanding the difference between these two metrics is crucial to making a well-informed investment decision. 

The dividend payout ratio is a metric that lets you know just how much dividend a company is paying relative to its earnings. It is represented as a percentage and can be calculated with the help of the below-mentioned formula. 

For example, if a company pays a dividend of Rs. 10 per share and its earnings per share (EPS) is Rs. 26, its dividend payout ratio would be 38.46% [(Rs. 10 ÷ Rs. 26) * 100]. This effectively means that a company pays out almost 38.46% of its total earnings as dividends. 

By comparing the dividend yield and the dividend payout ratio, you can effectively gain insights into whether a company can sustain its dividend payments over the long run or not. For instance, a high yield may be unsustainable if the dividend payout ratio is too high. This is because such a situation effectively indicates that the company is distributing a significant portion of its earnings and leaving very little for reinvestment or future growth.

Is High Dividend Yield Always the Best Indicator?

Although a high dividend yield is often preferred by many investors, it may not always be the best indicator of the attractiveness of an investment option. Firstly, dividend yields can be artificially inflated if the stock price falls sharply. And finally, maintaining a high yield consistently for years may put a lot of pressure on the company’s finances especially if its dividend payout ratio is also very high. And finally, 

Conclusion

Although the dividend yield is a good metric to consider, you should always take other financial metrics into account before making an investment decision. This will provide you with a more comprehensive view of a company’s financial health and help you make a better investment decision.